Neoclassical Story of the Monetary Policy Transmission Mechanism

The traditional orthodox story tells us that interest rates affect the economy through a number of channels including (i) the investment channel whereby higher interest rates reduce investment, as it becomes more costly to invest thereby inducing firms to either invest with retained earnings or forego investment because expected profits will be too low at higher interest rates (ii) the consumption channel, which is similar to the investment channel, in that higher interest rates make borrowing more expensive and so higher rates mean consumers cut back on big-ticket items such as houses, cars and white-goods; furthermore higher rates not only make borrowing plans more expensive, but also make actual borrowing more expensive: those with loans already will face higher payments and may thus cut-back elsewhere (iii) the wealth effect stems from the effect of rates on asset prices; higher interest rates mean investors can get higher rates from putting their savings in bank accounts rather than in the stock market (and other financial assets) and so demand for assets falls causing a fall in their price (pushing up the return on that investment) which leads to a negative wealth effect as asset prices fall (iv) finally we consider the export effect, whereby a higher interest rate increases demand for a domestic currency (hot money flows in to take advantage of the higher rate) causing an appreciation which leads to fewer exports and hence lower aggregate demand. [...]