The transmission mechanism of contractionary monetary policy, from the central bank's decision to its effect on demand-pull inflation, with the considerations that weaken or delay each link.
The central bank raises its policy rate.
The central bank raises the interest rate it sets for its dealings with commercial banks. This is the decision that starts the chain.
Central banks usually do this when they judge that aggregate demand is growing faster than the economy can sustain, threatening inflation above target.
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Banks raise the rates they charge borrowers and pay savers.
Commercial banks' own cost of funds rises, so they pass the increase on to the interest rates on loans, mortgages, credit cards and savings accounts.
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Loans, mortgages and credit become more expensive.
Households and firms that borrow now pay more interest. Existing borrowers on variable rates face higher repayments, which leaves them less disposable income to spend.
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Saving earns a higher return.
A higher return raises the opportunity cost of spending now rather than later, so some households choose to save more of their income.
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Higher returns attract financial inflows, so the currency tends to appreciate.
Relatively higher interest rates make the country's financial assets more attractive to foreign savers. Demand for the currency rises and the currency tends to appreciate.
How much this happens depends on interest rates elsewhere and on expectations, so this link is less predictable than the domestic ones.
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Fewer investment projects are worth financing.
A project goes ahead only if its expected return exceeds the cost of financing it. A higher interest rate raises that cost, so marginal projects are postponed or cancelled.
The interest rate is also the opportunity cost of using retained profits, so investment falls even for firms that do not borrow.
Residential investment, the building of new homes, tends to fall too, because higher mortgage rates reduce demand for new housing.
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Households spend less, especially on goods bought on credit.
Spending on durable goods that are often bought with credit, such as cars and furniture, is most sensitive to interest rates. (Building new homes counts as investment, not consumption, and is also sensitive to mortgage rates.)
Lower asset prices (for example, house prices) can also reduce consumption through a negative .
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A stronger currency makes exports dearer abroad and imports cheaper at home.
After an appreciation, exports cost more in foreign currency and imports cost less in domestic currency. Export volumes tend to fall and import volumes to rise, so net exports fall.
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Lower C, I and (X − M) shift AD to the left.
Because AD = C + I + G + (X − M), falls in its components shift the AD curve to the left. In the AD–AS model the economy moves down along SRAS to a new equilibrium, with a lower price level and lower real GDP than before the shift.
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Show this on the AD–AS diagramWith less demand pressing on capacity, inflationary pressure eases.
With less spending pressing against the economy's productive capacity, firms face less pressure to raise prices. The rate of slows.
On the AD/AS diagram this is the fall from P₁ to P₂. The diagram compares two equilibria with everything else held constant, so P₂ is a price level lower than it would have been without the policy. With prices rising to begin with, the result is : prices still rise, but more slowly. , a sustained fall in the price level, is a different outcome and is not what the policy aims for.
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Solid links are the core chain an answer should explain. Dashed violet links are evaluation: points that weaken, delay or qualify a link. Select any node or link label to read its explanation.