How monetary policy works
When a central bank changes interest rates, the effects spread through the economy over many months, through several channels.
Expansionary and contractionary policy
Expansionary (loose) monetary policy lowers interest rates to boost spending, output, and employment when the economy is weak. Contractionary (tight) policy raises rates to cool demand and reduce inflation when the economy is overheating.
The interest rate channel
Lower interest rates make borrowing cheaper and saving less rewarding. Firms invest more in equipment and buildings; households borrow more for homes and cars. Higher rates do the reverse. Housing and business investment are especially sensitive to interest rates.
Asset price and wealth channels
Lower rates tend to raise prices of shares, bonds, and houses, making their owners feel wealthier and spend more. They also improve borrowers' balance sheets, making it easier to get loans. Higher rates tend to lower asset prices.
The exchange rate channel
Lower domestic interest rates make a country's assets less attractive to foreign investors, tending to weaken its currency. A weaker currency makes exports cheaper and imports dearer, boosting net exports and also raising import prices.
Expectations and forward guidance
Monetary policy works partly through expectations. If people believe the central bank will keep inflation near target, they set wages and prices accordingly. Forward guidance, statements about the likely future path of rates, influences long-term interest rates today.
The Taylor rule
Economist John Taylor proposed a simple guide for setting rates: \(i = r^* + \pi + 0.5(\pi - \pi^*) + 0.5(\text{output gap})\), where \(r^*\) is the neutral real rate, \(\pi\) inflation, \(\pi^*\) the target. When inflation is above target or output is above potential, the rule calls for higher rates. Central banks use it as a reference, not a strict formula.
Lags in monetary policy
Monetary policy affects the economy with 'long and variable lags', as Milton Friedman put it: often a year or more for output and up to two years for inflation. Central banks must therefore act on forecasts, trying to anticipate where the economy is heading.
Worked example
Using the Taylor rule with \(r^* = 1\%\), inflation of 4%, a 2% target, and a zero output gap: \(i = 1 + 4 + 0.5(4 - 2) + 0 = 6\%\). If inflation fell to 2% with output at potential, the rule gives \(1 + 2 + 0 = 3\%\).
Key takeaways
Loose monetary policy lowers rates to boost demand; tight policy raises them to curb inflation. Effects work through borrowing costs, asset prices and wealth, the exchange rate, and expectations. Forward guidance shapes long-term rates. The Taylor rule links rates to inflation and the output gap. Effects take a year or more, so policy relies on forecasts.
Flashcard
Lower interest rates
Check your understanding
How does a cut in interest rates tend to affect a country's exports?