Preparing for CFA?

Practice tests, mock exams and readings with performance analytics. More Info

Monetary transmission mechanism

Even though central banks set short-term interest rates, their actions influence real economic variables at least in the short-run. For example, if a central bank increases its policy rate, the monetary transmission mechanism works through four channels:

Market interest rates

Commercial banks increase their base rates which decrease borrowing, which in turn decreases consumption and investment.

Changes in asset values

An increase in interest rate decreases asset values resulting in a decline in wealth and consequent decrease in consumption.


Increase in policy rate reduces expectations because economic agents expect consumption, investments, profits, etc. to fall and interest rate to increase further which cause them to reduce spending and investment further.

Exchange rate

An increase in interest level can appreciate domestic currency which would make exports costly and imports cheaper, resulting in lower inflation.


Which of the following is least likely a means through which monetary transmission mechanism works?

A) Changes in expectations of key economic agents.
B) Changes in the exchange rate.
C) Changes in government spending

Show answer

C is correct. Government spending is a measure of fiscal policy and it is the least likely to factor in the monetary transmission mechanism.

by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020

This article can help you prepare for Reading 16 LOSi.

Access complete notes and question bank   Login with Google Login with Facebook

More Articles

Monetary policy and fiscal policy Functions and definitions of money Money creation process Theories of demand and supply for money Fisher effect Roles and objectives of central banks Costs of expected and unexpected inflation Monetary policy tools Monetary transmission mechanism Qualities of effective central banks Inflation, interest rate and exchange rate targeting Limitations of monetary policy Fiscal policy tools and their advantages and disadvantages Budget deficit and national debt Fiscal policy implementation and problems Interaction of monetary and fiscal policy