A central bank sets one interest rate — the policy rate on overnight money. How does that single number reach the inflation a farmer pays and the investment a factory makes? Through the transmission mechanism: a chain of channels connecting the policy rate to spending, prices, and output. This module traces those channels — and explains why, in much of Africa, the chain is frayed, so the central bank pulls a lever only weakly connected to the economy.
The channels of transmission
- Interest-rate channel — the policy rate moves market and bank lending/deposit rates, which change the cost of borrowing and the return to saving, altering investment and consumption. The textbook core.
- Credit / bank-lending channel — policy changes the quantity of credit banks supply (via their reserves, balance sheets, and risk appetite), not just its price; tightening can ration credit, especially to bank-dependent borrowers.
- Exchange-rate channel — a higher policy rate attracts capital and appreciates the currency, which lowers import prices (directly cutting inflation) and reduces net exports. Important in open economies.
- Asset-price / wealth channel — policy moves bond, equity, and property prices, changing wealth and collateral and hence spending. Weak where asset markets are thin.
- Expectations channel — by signalling its stance and commitment, the central bank shapes inflation expectations, which feed into wage- and price-setting directly. Increasingly seen as central.
Why transmission is weak in developing economies
The broken transmission problem
Mishra, Montiel, and Spilimbergo (2012) document that monetary transmission is systematically weaker and less reliable in low-income countries. The reasons compound: • Shallow, illiquid financial markets — no deep bond or interbank market for the rate to propagate through. • Large unbanked and informal sectors — much of the economy borrows and saves outside the formal banking system the policy rate touches, often from informal lenders or not at all. • High cash use — limits the reach of the banking channel. • Weak, sticky interest-rate pass-through — banks often do not move lending rates much when the policy rate changes (below), so the price signal is muffled. • Concentrated, uncompetitive banking — a few banks with market power and ample liquidity feel little pressure to pass through policy changes. • Partial dollarisation and managed exchange rates — complicate the interest-rate and exchange-rate channels. The upshot: the central bank's lever is connected to the economy by a slack and elastic cable. Policy still works, but less predictably and less powerfully than the textbook implies — a fact that shapes everything from how aggressively the bank must move to how much it can be expected to achieve.
Weak interest-rate pass-through
The clearest symptom is weak pass-through: when the central bank cuts the policy rate, commercial banks' lending rates barely budge. Causes include uncompetitive banking (banks with market power keep spreads wide), high and sticky operating costs and risk premia (lending is risky and information-poor, so rates are high regardless of policy), ample structural liquidity (banks awash with reserves don't need to compete for funds), and a large spread between deposit and lending rates. Where pass-through is weak, the interest-rate channel — the textbook's main artery — is partly blocked, and the central bank's rate decisions reach borrowers only faintly.
When governments try to force it: the rate-cap lesson
Frustration with high lending rates and weak pass-through tempts governments to intervene directly. Kenya's interest-rate cap (2016–2019) — a legal ceiling on bank lending rates and floor on deposit rates — is an instructive case. Intended to make credit cheaper, it instead caused banks to ration credit to riskier borrowers (small firms, individuals) whom they could no longer price for risk, shrinking private-sector credit growth and pushing borrowers to informal lenders — the opposite of the intent. It also disrupted the transmission mechanism (the policy rate could no longer move lending rates freely) and was eventually repealed. The lesson connects to the whole public-economics toolkit: a price control that ignores why the price is high (risk, market structure, weak competition) treats the symptom and worsens the disease. The durable fix for weak transmission is structural — deepen markets, increase banking competition, improve credit information — not a cap.
Exercise
A central bank raises its policy rate by 200 basis points to fight rising inflation, but inflation barely responds and bank lending rates move only 40 basis points. (1) Trace how the hike is supposed to reduce inflation through at least three channels. (2) Diagnose why the effect is so muted, citing specific developing-economy features. (3) The finance ministry concludes 'monetary policy doesn't work here, so let's cap interest rates to help borrowers' — evaluate this using the Kenyan experience. (4) What structural reforms would strengthen transmission over time?