Impact of changes in interest rates on economic activity- transmission mechanism

Economists describe the process through which monetary policy impacts upon the economy as the transmission mechanism. It explains how changes in the stance of monetary policy pass through the economy to influence objectives such as inflation, economic growth and unemployment. 

The first transmission mechanism is known as the savings channel. The RBA’s rate cuts in the past 16 months mean consumers have less incentive to save due to lower returns. Since Y = C  + S, a fall in savings will correspond to an increase in consumption, which then directly stimulates Aggregate Demand (AD = C + I + G + X - M). This leads to greater GDP growth, inflation and lower unemployment in the short run. 

The next transmission mechanism is the investment channel. A reduced cash rate and therefore interest rates reduces the cost of borrowing for newly established businesses looking to undertake investment and expand their firm. Existing borrowers also now need less money to service corporate loans, leading to additional spending and further investment. Investment is a direct component of aggregate demand (AD = C + I + G + X - M). Therefore an increase in the level of business investment would also correlate with an increase in GDP growth and hence demand pull inflation in the medium term. The investment channel is best captured through the diagrams below.

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The final transmission mechanism is the exchange rate channel. A fall in the level of interest rates would discourage financial inflow into Australia, leading to a decrease in demand for the AUD, and therefore a depreciation. A depreciation makes Australia more competitive in both domestic markets (since imports are more expensive), and overseas markets (since exports are cheaper). Therefore, with greater exports and lower imports, Aggregate Demand increases (AD = C + I + G + X - M) , stimulating economic growth and adding to inflation. Higher output also generates greater levels of employment, as labour is a derived demand. 

Limitations of Monetary Policy 

Monetary policy has a wide range of limitations, which has significantly downplayed its effectiveness in the past 16 months. These limitations include: 

• Monetary policy is a blunt instrument meaning that it cannot be directed at specific parts of the economy, and is only able to increase Aggregate Demand as a whole. Therefore it fails to address the structural causes behind low inflation, including low wages growth, the decentralisation of labour, and weak household consumption.
• The Australian Prudential Regulation Authority’s (APRA's) credit and lending tightening has made it significantly harder for individuals and businesses to borrow money despite the incentive provided through the lower cash rate. 
• Monetary Policy has a long and variable time lag of 6-18 months as it is dependent on businesses and consumers changing their financial behaviours. Hence it is unable to facilitate an economic boom immediately, which the economy requires. 
• There is currently a lack of coordination between Fiscal and Monetary policy. While the RBA is pursuing an expansionary stance, the Australian government is doing the opposite with their 2019-20 budget forecasting a surplus of 7.1 billion dollars. The contradiction between the two macro policies counteracts and minimises the expansionary effects of the RBA’s cash rate cuts. 
• Monetary Policy continues to lose its effectiveness as it approaches the lower bound of 0, as it is more accustomed to contracting the economy. The lowering cash rate raises the prospect of significant issues such as banks refusing to pass on cuts to their respective interest rates.