David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

19. 7 The transmission mechanism
In calculating the likely transmission mechanism of UK monetary policy, the Bank of England therefore pays
close attention to the particular terms of outstanding mortgage contracts. This is one of many reasons why
changes in interest rates may take up to two years to have their full effect on aggregate demand. Overnight,
people are locked into old contracts that shield them for a while from the effect of the new interest rate. Even
after they feel its effect, it may take time to assess how painful it is and to look for alternative ways to behave.
Questions
(a) Suppose we are creatures of habit - calculating optimal behaviour takes time and effort so we recalculate
only rarely when it has become obvious to us that circumstances have changed substantially and previous
behaviour cannot possibly be optimal. Could this explain a delay in the transmission mechanism of
monetary policy even if there are no long-term contracts in force? Give an example.
(b) Would this justify a transmission lag in responses to fiscal policy too?
(c) Suppose interest rates can be changed frequently whereas fiscal policy changes are infrequent. Would
this help explain why people are slower to respond to monetary changes than fiscal changes?
To check your answers to these questions, go to page 686.
Finally, what about a rise in the quantity of consumer credit on offer? Figure 19.4 assumes that people
spend more than their incomes early in life. Students run up overdrafts knowing that, as rich economists,
they can pay them back later. What if nobody will lend? People without wealth are restricted by their actual
incomes, although people with wealth can lend to themselves by running down their wealth. Hence a rise
in the availability of consumer credit lets people dissave in the early years. Total consumption rises. More
students run up overdrafts and buy cars.
Having discussed how monetary policy affects consumption demand, we conclude our examination of
monetary transmission by analysing how interest rates affect investment demand.
Investment demand
In earlier chapters we treated investment demand as autonomous, or independent of current income and
output. We now begin to analyse what determines investment demand. Here we focus on interest rates.
Total investment spending is investment in fixed capital and investment in working capital. Fixed capital
includes factories, houses, plant and machinery. The share of investment in GDP fluctuates between 10
and 20 per cent. 5 Although the total change in inventories is quite small, this component of total investment
is volatile and contributes significantly to changes in the total level of investment.
In a closed economy, aggregate demand is C +I+ G. Public investment is part of G. We still treat government
demand as part of fiscal policy. Thus we assume that G is fixed at a level set by the government. In this
section we focus on private investment demand I.
Investment in fixed capital
Firms add to plant and equipment because they foresee profitable opportunities to expand output
or because they can reduce costs by using more capital-intensive production methods. BT needs new
equipment because it is developing new products for data transmission. Nissan needs new assembly lines
to substitute robots for workers in car production.
5 These numbers refer to gross investment: the production of new capital goods that contribute to aggregate demand. Since the
capital stock is depreciating, or wearing out, some gross investment is needed merely to keep the existing capital stock from falling.
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