AP MacroeconomicsMoney & Monetary Policy
Monetary Policy Transmission Mechanism
The transmission mechanism is the chain by which a central bank's interest-rate change passes through to investment, consumption, exchange rates, and ultimately AD and inflation.
A change in the policy rate works through several channels: the interest-rate channel (lower rates raise investment and interest-sensitive consumption), the exchange-rate channel (lower rates depreciate the currency and raise net exports), the wealth/asset-price channel (higher asset prices raise spending), and the credit/bank-lending channel (easier credit raises borrowing). Each channel shifts aggregate demand, so the same rate cut affects output and prices through multiple routes. Time lags mean the full effect on inflation arrives only after several quarters.