Interest Rate Transmission Mechanism

Introduction

This resource aims to provide some detail on the effect of changes in interest rates on different aspects of the economy - the interest rate transmission mechanism.

Image: House prices respond to changes in demand and supply and this in turn is influenced by the cost of buying a house - determined by the interest rate. Copyright: Esra Su, stock.xchng

The interest rate, more specifically the repo rate, is the main instrument of monetary policy. Monetary Policy refers to the attempts to influence aspects of the economy (growth, prices, employment, spending, etc.) through varying the price and supply of money in the economy. The Bank of England was given the responsibility to manage interest rates by the Labour Government in 1997 and has since used this instrument to maintain stable inflation rates, a target for which is set by the government, currently at 2%.

When the Bank of England decide to change the rate at which it will lend to the baning system (the repo rate), it has a knock on effect on many aspects of the economy. A 'repo' is a sale and repurchase agreement. It is effectively agreeing to sell something to someone, but guaranteeing you will buy it back at some given point in the future. In the money markets, repos are done by the banks and other financial institutions, with the Bank of England. When the banks are short of cash they sell some of their assets to the Bank of England in exchange for cash, but at the same time agree to buy them back at a later date (usually a fortnight). The assets that the banks are usually offering for repo are gilt-edged securities, Treasury bills and certain other bills and bonds.

Through this process the Bank of England can influence the structure of interest rates throughout the banking system, which is why when the Bank put up interest rates, households find that very soon after, their mortgage provider will increase the payments necessary on variable rate mortgages.

This resource is designed to show you how changes in the interest rate impact on different sectors of the economy and what the consequences might be. It uses animations to illustrate the processes involved and then poses questions to help develop your understanding of the transmission mechanism.

Please note: To make full use of the resource, your system must have Macromedia Flash Player 6 (or higher) installed - this can be obtained from the Macromedia Web site. Interactive Macromedia Flash resources developed by Biz/ed are designed to work both with and without the use of a mouse and be compatible with as many assistive technologies as possible (further information on our accessibility features is available in our accessibility statement). If you cannot view the interactive resources for whatever reason a static image will appear instead together with some descriptive text.

You can work through the resource step by step from the beginning or jump to a specific section using the listing below:

• The Pound/Dollar Exchange Rate
• The Pound/Euro Exchange Rate
• The Impact of a Rise in Interest Rates on UK Sterling Exchange Rate
• The Relationship Between Changes in Interest Rates and Exchange Rates
• The Balance of Payments:
  • Exports
  • Imports
  • Putting the Two Together
  • Neutral
  • Deficit
  • Surplus
• The Effect of Elasticity on Imports and Exports
  • Exports Elastic, Imports Inelastic
  • Exports Inelastic, Imports Elastic
  • Exports Inelastic, Imports Inelastic