Transmission Mechanism

A central bank directly controls only a short-term interest rate and its own balance sheet. The transmission mechanism describes how these actions ripple outwards through several channels.

The interest rate channel works through borrowing costs: higher policy rates raise rates on mortgages, loans and savings, encouraging saving and discouraging spending and investment. The asset price channel works through the value of shares, bonds and property, which tend to fall when rates rise, making people feel less wealthy. The exchange rate channel works through the currency: higher rates often strengthen it, making imports cheaper and exports less competitive. The credit channel works through banks' willingness to lend. Expectations also play a role.

For example, when a central bank raises rates, mortgage payments rise for some borrowers, house prices may soften and businesses may delay investment, gradually reducing demand and inflation.

The full effect of monetary policy usually takes a year or more, and the strength of each channel varies between countries and over time.