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The interest rate channel mechanism of monetary policy describes the mechanism how a policy-induced change in the short-term nominal interest rate by the central bank affects the price level and therefore output and employment.

How the interest rate channel works
While the central bank can control short term nominal interest rates, the real economy is mainly affected by long-term real interest rates charged by commercial banks to their customers. So the interest rate channel focuses on the effect that changes in the Banks’s policy rate have on various commercial interest rates.

The interest rate channel imposts that an increase in the short-term nominal interest rate induced by a central bank first leads first to an increase in longer-term nominal interest rates. This is described by the expectation hypothesis of the term structure.

This affects the real interest rate and the cost of capital as well, because prices are assumed to be sticky in the short-run. So an important aspect of the interest rate transmission mechanism is the emphasis on the real rather than the nominal interest rate, because this affects consumer and business decisions.

Accordingly, a decline in the long-term real interest rate reduces both the cost of borrowing and the money paid on interest-bearing deposits, and therefore encourages household spending on durable goods and firm investments. This rise in investments and durable good purchases by consumers boosts the level of aggregate demand and employment. This transmission mechanism can be characterized by the following diagram presenting the effects of a monetary expansion:

M↑ ⇒ ir↓ ⇒ I↑ ⇒ Y↑

Where M↑ shows an expansionary monetary policy which leads to a decrease in the real interest rate ir↓, which in turn lowers the cost of capital. This causes a rise in investment spending and consumer durable expenditure I↑, thereby leading to a rise in aggregate demand and an increase in output Y↑.

The interest rate channel is precisely the mechanism embodied in specifications of the “IS” curve of the Keynesian IS-LM model.

Monetary policy implications
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. .

However central banks should take into account that this transmission process takes time. Because although changes in the central bank’s policy interest rate can affect commercial interest rates quite quickly, there can be a significant lag before the interest rate changes influence spending and saving decisions and therefore have an impact on overall output. This is why monetary policy decisions have to be made well in advance with a view to the future.

Taylor rule
Taylor has a study on the interest rate channels and he shows that there is strong empirical evidence for significant interest rate effects on consumer expenditure and investments, making the interest-rate monetary transmission mechanism strong.

Criticisms
Despite this Taylor rule, many researchers as for example Bernanke and Gertler, had big difficulty in their empirical studies to identify significant effects of interest rate through the costs of capital. Moreover, since with the assumption that monetary policy has its strongest influence on short-term interest rates, as the federal funds rate.this rate is an overnight rate, monetary policy has a relatively weaker impact on the real long-term rate and therefore on the purchases of durable assets. Moreover there is neglect of the credit business of the banking system.

This shortcoming provided the stimulus for other transmission mechanisms of monetary policy, especially the credit channel. This channel should not be seen as a separate, free-standing alternative to the interest rate mechanism, but rather as a a set of factors that strengthen and transmit the interest rate effects.