Monetary policy actions are transmitted to the rest of the economy through changes in financial prices (e.g., interest rates, exchange rates, yields, asset prices, equity prices) and financial quantities (money supply, credit aggregates, supply of government bonds, foreign denominated assets). In recent years, financial price channels have attracted greater attention, partly reflecting concerns about stability of money demand functions. With the short-term interest rates emerging as the predominant instrument of monetary signals worldwide, the interest rate channel is the key channel of transmission. An increase in nominal short-term interest rate, given nominal rigidities (sticky nominal wages and prices in the short-run), translates into higher real interest rates. Higher real interest rates affect spending and investment behaviour of individuals as well as firms. By reducing disposable income, higher real interest rates depress current consumption. At the same time, higher real interest rates encourage current savings. In a similar vein, an increase in interest rates reduces profits of the firms. This makes fresh investments less attractive. Overall, consumption and investment declines which contracts output. This, in turn, pulls prices downwards. As wages/goods prices adjust over time, real GDP returns to the potential level and the real interest rate and the real exchange rate also return to their fundamental levels.

The transmission of monetary policy through interest rates is augmented by changes in the exchange rates and balance sheets of the firms as well as banks. Higher interest rates make domestic financial assets attractive and this induces an appreciation of the domestic currency. This has both a direct and indirect effect on prices. Depending upon the extent of the pass-through of exchange rate to prices, appreciation of the exchange rate lowers domestic prices of imports (the direct effect). At the same time, appreciation of the domestic currency adversely affects the external competitiveness of the economy. This leads to a reduction in net exports and, hence, in aggregate demand and output leading to a decline in prices (the indirect effect). Both the direct and indirect effects work in the same direction, i.e., reduce prices. Movements in interest rates also affect asset prices such as equity and property prices. An increase in interest rates depresses asset prices and the consequent reduction in wealth of households pulls down their consumption.

The effects of the conventional interest rate channel can get magnified due to market imperfections such as asymmetric information in financial markets. Recent literature has, therefore, stressed the importance of the credit channel of transmission. The credit channel is, however, not a distinct, free-standing alternative but rather a set of factors that amplify and propagate conventional interest rate effects. The credit channel makes a distinction between banks and non-banks as sources of funds on the one hand and between internal and external finance on the other hand. Within this view, two sub-channels are identified: the bank-lending channel and the balance-sheet channel. According to the bank-lending channel, banks play a special role since they are well-suited to deal with certain types of borrowers, especially small firms, where the problems of asymmetric information can be especially pronounced.

Thus, a contractionary monetary policy that decreases bank reserves also curtails banks' lending capacity. This reduces loans to small borrowers and hence aggregate spending in the economy. Large firms, in contrast, can directly access capital markets (bonds/ equities). The bank-lending channel is particularly relevant for developing and emerging markets with underdeveloped financial markets where interest rates may not move to clear the market. Banks may instead prefer to ration credit to obviate adverse selection problems. In such cases, aggregate demand is often influenced by the quantity of its credit rather than its price. Even in liberalised, developed financial markets, changes in credit conditions can influence economic activity and this forms the basis of the balance-sheet channel. According to the balance-sheet channel (also called net worth channel), higher interest rates reduce asset prices as well as cash flows of the firms. Taken together, these erode the net worth/collateral of borrowers restricting their ability to borrow. Due to asymmetric information, the reduction in collateral will increase the cost of external funds to firms, i.e., the firms have to pay a risk premium on external loans. This raises the external finance premium (EFP), which is the difference in the cost between funds raised externally (by issuing equity or debt) and funds generated internally. This has an adverse effect on investment and demand. These effects on demand and prices can get further reinforced through a 'financial accelerator' mechanism -the initial decline in demand further reduces the cash flows of firms and through its impact on collateral/EFP, output and price fall further.

The conventional views of monetary transmission discussed above focus on the demand side effects - a monetary tightening initially reduces output and then prices. In contrast, the "cost-channel" of monetary transmission stresses that supply-side or cost effects might dominate the usual demand-side effects and therefore, monetary tightening could be followed by an increase in prices. In this view, a rise in interest rates increases the cost of funds for bank-dependent firms. This raises the cost of holding inventories. Accordingly, the cost shock pushes up prices.