🔗 How Interest Rates Affect the Economy
The transmission mechanism describes how monetary policy works in practice.
Lower interest rates → (expansionary)
- Consumption (C) — borrowing is cheaper (mortgages, credit cards) → households spend more. Savings earn less → incentive to save falls → spend more.
- Investment (I) — firms borrow to invest at lower cost → more projects become profitable → I rises.
- Net exports (X − M) — lower rates → less foreign capital inflow → exchange rate depreciates → exports cheaper, imports dearer → (X − M) rises.
- Asset prices — lower rates push up house and share prices → wealth effect → more spending.
- Overall: AD shifts right → real GDP rises, unemployment falls. If economy near capacity, prices rise too.
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⬆️ The Contractionary Chain
Higher interest rates → (contractionary)
- C falls — borrowing costs rise → mortgage payments increase → less disposable income → spending drops. Higher savings returns → incentive to save more.
- I falls — cost of borrowing rises → fewer investment projects are profitable → firms cut back.
- Exchange rate appreciates — higher rates attract foreign capital → currency strengthens → exports more expensive, imports cheaper → (X − M) falls.
- Asset prices fall — higher rates reduce demand for houses and shares → negative wealth effect.
- Overall: AD shifts left → real GDP growth slows, inflation falls. Risk of overdoing it → recession.
In exams, always trace the full chain: interest rate change → effect on C / I / (X−M) → AD shift → effect on price level and real GDP. This structured approach earns full marks.
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✏️ Monetary Policy on AD/AS Diagrams
Expansionary monetary policy (rate cut)
- AD shifts right (from AD₁ to AD₂).
- Short-run equilibrium: higher real GDP (Y₁ → Y₂) and higher price level (P₁ → P₂).
- If economy was in a deflationary gap, the gap narrows — unemployment falls.
Contractionary monetary policy (rate hike)
- AD shifts left (from AD₁ to AD₂).
- Short-run equilibrium: lower real GDP and lower price level.
- If economy was in an inflationary gap, the gap narrows — inflation falls.
Monetary policy shifts AD — it does NOT shift AS. It's a demand-side tool. To shift LRAS, you need supply-side policies (topic 3.7).