. and a very relevant factor in the psychological problem is the traders ’ expectations as to the intentions of the authority which fixes rates. ” - - monetary reconstruction by walter bird, bromide print, 1958 © national portrait gallery, london ( cc by - nc - nd 3. 0 ) chart 3 monetary policy discussions by economists in the uk in the first half of the 20th century ralph george hawtrey ( 1879 - 1975 ) by walter bird, bromide print, 1958 © national portrait gallery, london ( cc by - nc - nd 3. 0 ) effects of interest rate policy “ the pressure applied to traders by a moderate rise in the shortterm rate of interest, say, 1 percent, is undeniably very slight. yet apparently the bank of england always counted on a rise of 1 percent or even of 0. 5 percent having a noticeable effect. ” “ in the first place, when the use of bank rate to restrict credit became an established practice, traders, being aware of the intentions of the bank, were inclined to anticipate them. when bank rate went up from 3 to 4 percent, a trader would reason that this was intended to have a restrictive effect on markets, and that, if the effect was not brought about, the rate would simply go higher and higher till it was. those who took that view would restrict their purchases and demand would fall off, and so the 4 percent rate might be found potent enough, even though, if unsupported by traders'anticipations, a 6 or 7 percent rate might have been necessary. ” - - a century of bank rate chart 4 monetary policy discussions by economists in the uk in the first half of the 20th century announcement effect of monetary policy john richard hicks ( 1904 - 1989 ) “ i want to use the announcement effect of an act of policy to mean the change which takes place in people's minds, the change in the prospect which they think to be before them, before there is any change which expresses itself in transactions of any kind. it is the same as what hawtrey calls'psychological effect'; but that is a bad term, for it suggests something irrational, and this is entirely rational. expectations of the future ( entirely rational expectations ) are based upon the data that are available in the present. an act of policy is a significant addition to the data that are available ; it should result, and should almost immediately result, in a shift in expectations. this is what i

a very relevant factor in the psychological problem is the traders'expectations as to the intentions of the authority which fixes rates. " in other words, hawtrey highlighted that private entities decide their actions based on expectations for the future, identifying - at this extremely early stage in the study of economics - - that the central bank's policy stance toward future price stability is an important factor working on the expectations of such economic entities. hawtrey also provides us with instructive insights about why interest rate control by the central bank produces significant policy effects ( chart 3 ). in his 1938 book a century of bank rate, he argues that " [ t ] he pressure applied to traders by a moderate rise in the short - term rate of interest, say, 1 percent, is undeniably very slight. yet apparently the bank of england always counted on a rise of 1 percent or even of 0. 5 percent having a noticeable effect. " he continues by stating that, when the bank of england raises the official discount rate by 1 percent, " a trader would reason that this was intended to have a restrictive effect on markets, and that, if the effect was not brought about, the rate would simply go higher and higher till it was. " hawtrey thus probably was the first to clearly point out that the reason why a minor change in the policy interest rate creates a major policy effect is people's expectations regarding the future monetary policy stance of the central bank. i vividly remember hearing about this last point from professor john richard hicks during my days at oxford. however, while hawtrey called this policy effect resulting from people anticipating the intentions of the central bank the " psychological effect, " hicks argued that the effect was based on extremely rational behavior of economic entities ( chart 4 ). from a theoretical perspective, hicks found this to be a stronger argument with regard to the transmission mechanism of monetary policy than hawtrey's argument. hicks called this the central bank's " announcement effect, " saying that the central bank's policy " should almost immediately result in a shift in expectations, " and that " [ w ] hat i learn from hawtrey's analysis is that the'classical'bank rate system was strong, or could be strong, in its announcement effects. " this identification of the announcement effect by hicks is based on the so - called expectations theory with regard to long - term interest rates. he therefore can be said to have pointed out at an early