Show all three channels by which changes in interest rates affect economic activity. Under what conditions might expansionary monetary policy, that is, lower interest rates might not greatly affect domestic economic activity? (4 marks)
The interest rate channel is a mechanism of monetary policy, whereby a policy-induced change in the short-term nominal interest rate by the central bank affects the price level, and subsequently output and employment. The interest rate channel plays a key role in the transmission of monetary impulses to the real economy. The central bank of a major country is, in principle, able to trigger expansionary and restrictive effects in the real economy, by varying the federal funds rate and hence the short-term nominal interest rate. However, it is difficult to explain how, with this channel, a central bank might target a relatively stable and low inflation rate of a longer time period. Although changes in the central bank’s policy interest rate can affect commercial interest rates quite quickly, there can be a significant lag before those changes influence spending and saving decisions, in turn having an impact on overall output.