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Monetary Policy - Monetary Policy Committee

Theory 1 - Monetary Transmission Mechanism - what are the links between the interest rate and inflation?

Stage 3

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The first two stages in the transmission mechanism show how the change in interest rates affects the level of spending in the economy. The total of all spending is aggregate demand. Aggregate demand (AD) is therefore:

Aggregate Demand = Consumption + Investment + Government expenditure + (Exports - Imports)

The effect of changes in aggregate demand on inflation depends on whether the economy has the capacity to produce the goods and services being demanded. This capacity is aggregate supply (AS). There is always a certain level of AS at which all firms are working to their normal capacity. This level of output is called the 'potential' level of GDP.

If AD is less than AS, then the economy has spare capacity. The 'actual' output is below the 'potential' output. This situation is called a 'negative output gap' or 'deflationary gap', and any increase in AD can be accommodated by simply increasing production. This is unlikely to have any inflationary effects.

Inflation is likely to be caused by the opposite situation. Where AD is greater than AS, then the economy is trying to produce more than its potential. This situation is called a 'positive output gap' and is likely to be inflationary. This can perhaps easiest be thought of as 'too much money chasing too few goods'. It is known as demand-pull inflation, because demand is literally pulling up inflation. On the diagram below we can see that as aggregate demand rises, so prices increase as well; inflation.

If the capacity of the economy is growing, then the level of demand can also grow without any effect on inflation. However, the growth in aggregate supply will depend on the supply-side policies that are being pursued by the government and the pace of technological change. The MPC can't do anything about either of these, and so they have to look carefully at what is happening on the supply-side of the economy to try to work out how much demand can be allowed to grow by.

However, there are two more very important factors when looking at the growth of demand. The first is any secondary effects or multiplied effects there may be on aggregate demand. The second is time lags. How long does it take for the interest rate changes to have their full effect, and how significant is that effect?

Second-round effects

Many firms will not be directly affected by all the changes we have outlined. They may not trade overseas and so may not be affected by the exchange rate. They may not have borrowed much and so may not be affected by higher interest repayments and so on. Despite this though they may be affected positively or negatively by the interest rate changes made by the MPC. As aggregate demand increases or decreases, most firms will be affected somehow. Retailers may find their sales rising or falling, even though they have not been directly affected themselves. A steel-maker may benefit from the increased level of demand for cars and so on. It is quite important to try to assess how significant these secondary effects are because they will add significantly to aggregate demand, and could therefore be inflationary.

Time lags

Any change in the interest rate takes time to have its full effect on the economy. Though financial institutions and many markets will react immediately, it may take much longer for these effects to feed through to spending. Though a mortgage holder may know that the mortgage rate has changed it may be a couple of months or perhaps more before it is noticed as a lower bank balance! It is only then that they begin to react by cutting spending elsewhere.

These time lags are significant. The empirical evidence suggests that it may take up to a year for the monetary policy change to have its full effect on demand and production. The full effect on inflation may take up to two years.