The document summarizes the monetary policy transmission process in Australia. It explains that when the central bank raises cash rates, it works through various transmission channels to ultimately affect aggregate demand and the macroeconomic objectives of inflation, employment, and economic growth. Specifically, higher interest rates impact savings and investment decisions, asset prices, exchange rates, and business and consumer expectations. Together these transmission channels can cause consumption and investment to fall and exports to become relatively more expensive, thereby reducing aggregate demand in the economy.

1. (c) Andrew Tibbitt 2017 Slide 1
Monetary Policy
Part 3 - Transmission process
WACE Economics – Unit 4
Slideshow 14.3

2. (c) Andrew Tibbitt 2017 Slide 2
The process by which changes in cash rates affect the
level of economic activity is known as the
TRANSMISSION MECHANISM
Change in
cash rates
Changes in
aggregate
demand
Changes in
macroeconomic
objectives
Changes in
other interest
rates
Stage 1 Stage 2 Stage 3
How does monetary policy work?

3. (c) Andrew Tibbitt 2017 Slide 3
Change in
other interest
rates
Changes in
components
of aggregate
demand
Savings and
investment decisions
Exchange rate
changes
Cash flow of
households and firms
Asset prices (houses
bonds, shares)
Monetary climate
(confidence, climate)
C + Ip
X - M
C + Ip
C + Ip
C + Ip
S
E
C
A
M
INTERTEMPORAL SUBSTITUTION EFFECT
EXCHANGE RATE EFFECT
CASH FLOW EFFECT
ASSET PRICE EFFECT
EXPECTATIONS EFFECT
Change cash
rates

4. (c) Andrew Tibbitt 2017 Slide 4
Impact on savings and investment
Rates of
interest
RISE
Better reward for saving
More expensive to use
credit for consumption –
higher opportunity cost
Higher cost of borrowing
makes some investment
decisions unprofitable
SAVINGS UP
CONSUMPTION
DOWN
PLANNED
INVESTMENT
DOWN
Known as the inter-temporal substitution effect, interest
rate changes alter decisions about spending, saving and
borrowing

5. (c) Andrew Tibbitt 2017 Slide 5
Exchange rate effect
Rates of interest rise
Bigger interest rate differential between Australian rates
and rates in other countries
Assuming other world interest
rates stay the same
‘Hot money’ flows financial inflows
AUD Exchange rate appreciation
Harder to export, cheaper to import
Reduction in net exports (lower exports, more imports)
creates
encourages
which leads to, other things being equal to
which makes it
and, assuming sufficient price elasticity

6. (c) Andrew Tibbitt 2017 Slide 6
Cash flow effect
Rates of interest rise
Monthly payments on variable interest loans rise
Reduction in income left for other spending
Consumption and business investment falls

7. (c) Andrew Tibbitt 2017 Slide 7
Rates of interest rise
Asset price effect
Borrowing to
buy houses
less attractive
Fall in demand
for housing and
a fall in property
values
Fall in wealth
Fall in consumption and planned investment
Dividend return
from shares looks
less attractive.
Gloomier outlook
for company
profits
Share prices fall
Bond prices fall
(there is an
inverse
relationship)
makes
causing
leads to
causing
causing
leads to

8. (c) Andrew Tibbitt 2017 Slide 8
Expectations effect
Rates of interest RISE
People sense that RBA is telling them
that economic conditions are worsening
Reduced consumer and business
expectations
Consumption falls Business investment falls
A change in interest rates sends a signal to consumers and
producers and alters their mood and the climate of decision
making

9. (c) Andrew Tibbitt 2017 Slide 9
Consumption
 Intertemporal substitution
effect
 Asset price (wealth) effect
 Cash flow effect
 Expectations effect
Planned Investment
 Intertemporal substitution
effect
 Asset price (wealth) effect
(houses)
 Cash flow effect (for
business)
 Expectations effect
Government spending
 No obvious impact
Net exports
 Exchange rate effect
Summary of transmission process

10. (c) Andrew Tibbitt 2017 Slide 10
A change in aggregate demand affects
macroeconomic performance
Rise in cash rates,
after an effect lag,
leads to fall in
aggregate demand
Fall in aggregate demand leads to:
 Lower demand-pull inflation
 Lower demand-deficiency
employment
 Slower growth
 Narrower trade gap

11. (c) Andrew Tibbitt 2017 Slide 11
End of part 3