Answers
The implementation of the policy may begin to work through the economy via four interrelated channels. Those channels include bank lending rates, asset prices, agents' expectations, and exchange rates. - First the base rates of commercial banks and interbank rates should rise in response to the increase in the official rate. Banks would, in turn, increase the cost of borrowing for individuals and companies over both short- and long-term horizons. Businesses and consumers would then tend to borrow less as interest rates rise.
An increase in short-term interest rates could also cause the price of such assets as bonds or the value of capital projects to fall as the discount rate for future cash flows rises. Market participants would then come to the view that higher interest rates will lead to slower economic growth, reduced profits, and reduced borrowing to finance asset purchases. Exporters' profits might decline if the rise in interest rates causes the country's exchange rate to appreciate, because this would make domestic exports more expensive to overseas buyers and dampen demand to purchase them. The fall in asset prices as well as an increase in prices would reduce household financial wealth and therefore lead to a reduction in consumption growth. Expectations regarding interest rates can play a significant role in the economy.
Often companies and individuals will make investment and purchasing decisions based on their interest rate expectations, extrapolated from recent events. If the central bank's interest rate move is widely expected to be followed by other interest rate increases, investors and companies will act accordingly. Consumption, borrowing, and asset prices may all decline as a result of the revision in expectations. There is a whole range of interconnected ways in which a rise in the central bank's policy rate can reduce real domestic demand and net external demand (that is, the difference between export and import consumption).