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.

Expectations

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.

Test

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.

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