Recap
the transmission mechanism of monetary policy
In the Inflation section
we set out in general terms how a change in the official Bank Rate affects inflation over a period of time. We discussed
how it leads to changes in spending and how this influences
output and, in turn, the rate of inflation. The Inflation
Outlook section expanded on this discussion. This section
will add to this material by looking at different aspects of
the economy and how we monitor developments to judge the future
path of inflation.
The diagram below illustrates the basic features of the transmission mechanism - the route by which an interest rate decision influences the rate of inflation. It portrays how the rate of inflation is the product of the degree of inflationary pressure within the UK economy, and the influence on domestic prices from import prices. The diagram will refresh your understanding of what has been discussed earlier and provide a quick reference point as you are looking at the material in this section and the data that accompany it.
key points
The
official Bank Rate affects other interest rates - such as mortgage
rates and bank deposit rates. At the same time, policy actions
and announcements affect expectations and confidence about
the future course of the economy. They also affect asset prices
and the exchange rate.
These changes in turn affect the spending, saving and investment behaviour of individuals and firms in the economy. Higher interest rates will tend to encourage saving rather than spending, and a higher value of sterling in foreign exchange markets - which makes foreign goods less expensive relative to goods produced at home.
The level of demand in money terms relative to the supply capacity of the economy - in the labour market and in product markets - determines inflationary pressure in the economy. If the demand for labour exceeds the supply available, there will tend to be upward pressure on wage increases, which some firms might pass through into higher prices charged to consumers.
Exchange rate movements have a direct, though often delayed, effect on the prices of imported goods and services, and an indirect effect on the prices of domestic goods and services that compete with imports and use imported materials and other inputs.
the transmission mechanism of monetary policy 
Click on the image for a larger version
Having a good feel for the transmission mechanism will help the teams to identify how information and signals from different aspects of the economy might influence future inflation.
©2000-2009 Bank of England.
