Channels through which monetary policy affects interest rate

Interest Rate Channel

The expectations of the central bank’s short-term rates of interest affect the medium as well as the long-term rates on interest. Once a change is induced in the short term interest rates, there is a shift in the entire interest rate curve. The nominal rate of interest, however, is dependent on the inflation expectations in various time periods. An increase of the real interest rate causes the consumption of opportunity cost leading moderate consumption and eventually affecting inflation rate. There is a strong interaction between the rate of exchange variation and the monetary policy. Evidence has shown that there is a reaction to the exchange rates which occurs immediately and the news on the monetary policy (Bjørnland, 28). Since monetary policy reacts to changes in the exchange rates, it is expected that reaction between the rate of exchange and the rate of interest to be of great importance in the monetary policy analysis. Research shows that there is shocks depreciate of the rate of exchange which one percent while increasing the interest rate. There is also a monetary policy impact on the exchange rates.

Expectations Channel

The decisions made by the monetary policy affect future expectations of economy performance, particularly, prices. Prices are thus determined by economic agents using these expectations. Since the rate of interest is affected by the expectations of inflation, the aggregate demand and supply are also affected. Therefore, firms’ provisions on cost as well as future revenues are crucial in determining prices or production levels. The zero lower bound has apparently affected the small economies of the world. For instance, when the debt crisis in euro area occurred, the small economies were restricted by the central bank since it was unable to respond to all the currency shocks (Klein and Jay C, 76). When the monetary regimes that result to ZLB occur, the small economies are affected negatively since the effect of the central bank on the economy is reduced. Bold policies, on the other hand, trigger large exchange rate fluctuations in the small economies. Anchoring the inflation rate expectations leads to a large response by the price levels as well as the exchange rate of the small economies (Bauerle & Kaufmann, 89).

Exchange Rate Channel

Increased interest rates cause the domestic financial assets to attract investors compared to financial assets from foreign countries. The nominal rate of exchange is thus triggered leading to the reallocation of expenditures in the economy. Import prices are lowered, and the export prices increase thus leading to an appreciation in the rate of exchange. Finally, the economy experiences low inflation as well as a decline in the aggregate demands. Low-interest rates have been maintained by the central bank advanced economies leading into a debate on the global liquidity nature as well as its transmission across the border.

In the advanced economies, low-interest rates facilitate cross-border capital flows. Global banks leverage cycle is the driving factor of the banking sector capital flows. Banks are intermediary who often borrow short but at the same time lending long hence the term spread size influences the new lending profit. Because low rates are more sensitive as compared to long rates, there is a considerable influence exerted by the monetary policy on the terms size spread for short periods (Zettelmeyer, 54). The central bank system can thus act on the economy directly through greater risk-taking by the banking sector.

Negative Effects

Other Asset-Price Channel

When interest rates increase, bonds become favourable to the investors thus reducing equity demand and lowering the value of the other assets. If the market value of firms happens to decrease, companies are more likely to have a low capacity of accessing finances, thus hindering new investment projects in the firms. The aggregate demand is also slowed down thus reducing inflation. There are various transmission mechanisms in the monetary policy which influence all the entire exchange rate in an economy. They include the traditional interest rate channels which operate within other asset prices as well as the credit channels which receive most of the research attention. Traditional interest rate channels are the key monetary transmission mechanism.

It not only operates through business decisions on investment but also via the decisions of customers on expenditure (Faust and John, 35). Other asset price channels, on the other hand, are illustrated by Keynesian affects prices as well as the monetary mechanisms. Under it, the rate of exchange channel has a significant function in the effects of the domestic economy. It also operates under the land as well as the housing price channels. Finally, the credit channels are affected through bank lending as well as the channel balance sheet. Thus, the bank channel of lending basis its view on the special role of the financial system since the credit market helps to solve asymmetric information (Mishkin, 53).

Credit Channel

When the interest rate increases, it promotes a decreased investment credit as well as consumption. This is because an increase in credit rate leads to increased credit cost. In the ultimate end, a decrease in consumption as well as investment causes a reduction in aggregate demand and lowers inflation. According to research, the returns of other currencies in the U.S are higher. There has been engagement on the currency trade by the financiers who are willing to bear the extra risk of the conditions that they are compensated with higher returns. Therefore, there is an increase in the uncertainty of the monetary policy since the FOMC announcement causes the foreign currencies to depreciate in value against the dollar of the U.S resulting in a possible appreciation in future (Cushman and Tao, 89). Monetary policy uncertainty also results in the increase in excess returns which is high for the interest rates that are large. It is because, despite the fact that there is an exchange rate adjustment induced by large interest rate differential, the change can’t offset exchange rate differential increase due to the risk bearing constraints hence resulting in the excess overall returns.


From the discussions above, it can be concluded that the channels of transmitting monetary policy are complementary since they operate simultaneously. The monetary policy has a role in the global liquidity transmission. It leads to increase or an increase in interest rates of economies through the channel of global liquidity transmission. There is a relationship between the reduced rate of interest in advanced economies and the high-interest rates amid currency appreciation in the developing economies. When a cross-border banking model is viewed, it reveals the risk-taking channel in the monetary policy which operates via feedback loop between falling risks and global banks increased leverage. For instance, when the interest rate of the US dollar falls, a depreciation of the dollar follows consequently. Thus, the high bank leverage caused by the low interest rate on the dollar leads to cross-border flow of capital as well as an appreciation of the currency of the recipient economy (Bruno, 56).

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