A type of credit channel that reflects the direct effect of a policy induced change in a central bank’s policy rate (policy interest rate) on money-market interest rates and the indirect effect on lending and deposit rates set by individual banks set for their customers.

An increase in the short-term nominal interest rate– according to the expectations hypothesis of the term structure of interest rates– would prompt an increase in longer-term nominal interest rates. Businesses considering that their real cost of borrowing over short term and long term has increased, will react by cutting back on their investment expenditures (operational expansion) or further employment. Likewise, individuals facing higher real borrowing costs will reduce their purchases of assets such as homes, automobiles and other durable goods. Overall, supply and demand in respective markets will be affected, and largely create a downward pressure on inflation.