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Understand economics at your own pace: step-by-step guided courses, and exercises to practice.
The policy rate and transmission
How a single ECB decision changes the price of money everywhere.
↑ policy rate → ↑ loan rates → ↓ demand → ↓ inflation (1 to 2 years)Problem / motivation
July 2022: the ECB begins the fastest tightening in its history — its rate goes from 0% to 4.5% in fourteen months. French mortgage rates follow: from about 1% to more than 4%. And yet, if you had already borrowed, your monthly payment did not move by a cent — and inflation only gave way a year later. This course takes apart the three puzzles: why rates follow, who is protected, and why it is all so slow.
Three words first. An INTEREST RATE is the price of a loan — so many % a year (and a “point” is the unit of gap between two rates: going from 2.00% to 2.25% is +0.25 point). COMMERCIAL BANKS — yours — constantly need liquidity, and can borrow it from the CENTRAL BANK (in the euro area: the ECB — course “What is a central bank?”). The POLICY RATE is the price at which the central bank lends to banks, at very short term: the WHOLESALE PRICE of money. (The ECB in fact posts several — refinancing 4.5%, deposit 4% in 2023; it is the deposit rate that has led the way since banks have had more liquidity than they need. Hold on to the idea: ONE reference rate, which the ECB moves.)
When the wholesale price goes up, banks pass it on to their retail prices — loans — adding their margin. Dearer credit brakes purchases and investment: DEMAND slows. And slowing demand calms the rise in prices. Policy rate → loans → demand → prices: this cascade is called the TRANSMISSION MECHANISM, and each link has its own lag — it is what this course unrolls, link by link.
Assumptions
In your view, which assumptions are needed for this model to hold? Jot down your ideas — no lead is wrong, this is your worksheet.
Your worksheet is still empty. Go for it: propose at least one idea.
0 idea(s) proposedFormalization
It all starts with a decision: the central bank moves the policy rate, the price at which banks fund themselves at very short term (assumption 1). It decrees nothing else — neither your loan rate nor your savings rate. One single dial, turned in Frankfurt: all the rest is pass-through.
The retail price follows the wholesale price: loan rate = policy rate + MARGIN — the margin covering the bank's risk, overheads and profit (assumption 2). It is the only new equation in this course, so let us say it plainly: it is a TOY, faithful for short rates, simplified for long ones — a fixed-rate mortgage is set above all by EXPECTATIONS of future rates, which is why it climbed from early 2022, before the first rise (interpretation, point 3).
What decides whether you borrow or not is not the advertised rate but what it REALLY costs: the real rate ≈ nominal − inflation (assumption 3). The intuition: you repay with euros that the rise in prices has devalued — if inflation exceeds your rate, it repays part of the loan in your place. (The “≈” is this site's shortcut: the exact version divides the coefficients — courses “Inflation and purchasing power”, “Do your savings beat inflation?”.)
Credit that is really dearer → fewer purchases on credit, less investment: DEMAND slows — slowly, because the fixed-rate stock is protected (assumption 4). And slowing demand disarms the rise in prices: inflation gives way last, 12 to 24 months after the decision. There is the complete cascade of the header — every arrow dated. Click each term of the link-2 equation:
Solving / calculation
Let's replay the 2022-2024 episode link by link, with the real figures — then handle the toy in the simulator.
- Link 1 — the ECB raises its wholesale price (July 2022 → Sept. 2023)
policy rate: 0 → 4.5%ten rises in fourteen months - Link 2 — mortgage rates follow, damped and ahead of time
mortgages: ≈ 1 → ≈ 4.3%+3.3 points for +4.5: partial pass-through (they set off in Dec. 2021, expectations obliging — the windows do not coincide exactly) - Link 3 — the real rate flips: the bite only comes in 2024
end 2022: ≈ 2.3 − 10; mid-2024: ≈ 3.7 − 2.5real: ≈ −8% → ≈ +1% — as long as it was negative, the tightening did not bite - Link 4 — demand brakes… through NEW loans only
fixed-rate stock: unchangedmonthly payments under way do not move — the 2nd puzzle - Link 5 — inflation gives way last
peak 10.6% (Oct. 2022) → ~2%back towards target during 2024: one to two years
The three puzzles are solved: loans follow the wholesale price (link 2, partially — long rates); borrowers already committed at a FIXED rate are protected, and only new ones pay (link 4); and the slowness is PUT IN FIGURES at link 3 — as long as the real rate stayed negative, the policy did not bite: inflation only gave way after the flip, one to two years in all, the poll's figure readable in the history itself.
loan rate = policy rate + margin · real ≈ nominal − inflationThe link-2 toy, adjustable: wholesale price, margin, pass-through to long rates (2022-2023: about 70%), inflation. Short rate, long rate and real cost follow — and the reading line says whether the policy BITES.
Economic interpretation
One dial in Frankfurt, three lessons for reading it: the direction, the bite, the channels.
Raising rates — economists call it a RESTRICTIVE policy: it brakes — cools credit, demand and prices; cutting them — an ACCOMMODATIVE policy: it stimulates — warms everything up — at the risk of reviving inflation. But France borrows at fixed rates: the stock of loans under way is watertight, and transmission only runs through NEW borrowing — hence its slowness, and the obligation to act ahead of time, on forecasts (assumption 4).
As long as inflation exceeds the nominal rate, the real rate is negative: borrowing stays subsidised by the rise in prices, and the policy brakes nothing. That is why the ECB had to go to 4.5% against double-digit inflation — and why “high rate” means nothing without looking inflation in the face (link 3). The central banker in fact does the computation BACKWARDS: they start from the real rate they want to reach and climb back up the cascade — target real + expected inflation − margin = the policy rate needed; exercise 6 has you do it.
The credit cascade is not alone. The EXCHANGE RATE: higher rates attract capital, the euro appreciates, imports cost less — bonus disinflation. LENDING CONDITIONS: more cautious banks lend less, at an unchanged rate. And EXPECTATIONS, the fastest channel: long rates move on the ANNOUNCEMENT — which is why mortgage rates were rising from early 2022, before the first hike. Sometimes, saying is almost enough to do.
Limits / critiques
Exercises
Policy rate at 2.5%, bank margin of 1 point. What nominal rate for the loan (link-2 toy, in %)?
The ECB wants to BRAKE inflation. What does it do with its policy rate?
The ECB raises its rates sharply. Who is MOST protected?
French mortgage rates started rising in early 2022, BEFORE the ECB's first hike (July). Why?
Loan at 3.5%, inflation at 1.5%. What is the approximate real cost (in %)?
True or false: with a loan advertised at 4% and inflation at 6%, the borrower bears a negative real cost.
Expected inflation: 3.5%; bank margin: 0.5 point. What MINIMUM policy rate is needed for the real cost of the loan to reach at least +1% (toy, in %)?
True or false: a rise in the policy rate brings inflation down from the following month.