The interest rate channel

The interest rate channel influences demand for goods and services and thereby resource utilisation with a certain delay. In turn, changes in resource utilisation then affect inflation with a certain time lag.

 

Higher interest rates normally lead to a reduction in household consumption. This happens for several reasons. Higher interest rates make it more attractive to save, in other words to postpone consumption, thus lowering present consumption. Consumption also declines because interest payments on existing loans rise and because consumers are less inclined to take new loans to finance purchases. Finally, a similar effect is exerted through lower asset values. The price of both financial and real assets - shares, long bonds, property, etcetera - falls in that the present value of future returns drops when interest rates rise. When faced with dwindling wealth, households become less inclined to consume.

 

A rise in interest rates also makes it more expensive for firms to finance investment. As a result, higher interest rates normally curtail investment as well. Consequently, higher interest rates lead to a drop in demand from both households and firms. If consumption and investment fall, so does aggregate demand.

 

Lower aggregate demand results in lower resource utilisation. The relationship between resource utilisation and inflation is often described as the Phillips curve. According to this relationship, prices and wages usually rise at a more moderate rate when resource utilisation is low. However, it takes time before a decline in resource utilisation leads to a fall in inflation. This is partly because wages do not change from month to month but more seldom than that.


LAST UPDATED 3/23/2004