In this week's BNZ Weekly Overview Tony Alexander gives a simple lesson in how monetary policy works:

The Reserve Bank has as one of its tasks keeping inflation between 1% and 3% on average over the business cycle.

Inflation is heavily influenced by how fast the economy is growing in relation to growth in resource availability (labour, machinery, buildings) and gains in productivity.

If the RB is worried about inflation in 18 - 24 month's time it will try to slow down growth in the economy in order to reduce pressure on resource prices.

It does this by altering the cost to you and I as businesspeople and householders of borrowing money to buy stuff.

When the cost of borrowing money - the interest rate - goes up we tend to borrow less, therefore we spend less and as retailers sell fewer things they order fewer and those making things cut back their demand for resources - like employees - and inflationary pressures abate.

At the same time as interest rates rise we tend to save more and that also means less spending.

 The exchange rate also tends to rise but we shall leave that out of this particular discussion.

So how does the RB influence the cost of borrowing - bank lending rates to businesses and households?

It raises and lowers something called the official cash rate. In simple terms this is the cost to us banks of borrowing money for 24 hours from the RB if we need to square our overnight account with them.

If the cost of squaring one's account (some nights one is short, some long) is a lot then one will want to avoid that by borrowing off other banks during the day - and paying more and more in order to do that - or borrowing more money for say 90-day periods - and again raising the interest rate one is prepared to pay to get that money on board.

In this way a change in the OCR affects how much we banks are prepared to pay when we sell bank bills to raise money. The longer we think the OCR will rise and stay high the more we will be prepared to pay for rates of longer and longer duration - six months, one year, five years.

So moving the OCR moves wholesale bank funding costs (and we raise our term deposit rates also to get funds in) as long as we expect the OCR to stay up. This is where verbal intervention by the RB becomes important.

The harder they talk with regard to inflation being a problem and needing to raise rates a lot for a long time the more scared we banks will be of being caught short and paying a high OCR down the track so the more we will be prepared to raise our bank bill yields and term deposit rates.

But what happens if the RB raises the OCR and we banks don't raise our lending rates - maybe because we feel they will cut the OCR again very shortly because we think they are over-estimating inflation, or because we decide to cut our margins to try and perhaps get lending market share from each other?

In that case if an OCR rise does not lead to higher bank lending rates there will be no new downward pressure on borrowing, no reduced growth in business and consumer spending, no reduced orders for goods and services from suppliers, and therefore no reduced pressure on resource prices. Monetary policy will not have changed.

Excluding the exchange rate link monetary policy only works if bank lending rates change.

If they don't then the RB will have learnt it needs to raise the OCR more than it thought. Meaning in very simple terms now, if a round of bank lending rate increases had not followed the OCR increase of June 10 the RB could have decided to raise the cash rate 0.5% on July 29 rather than just the 0.25% we expect in order to force us banks to raise our lending rates.

As for borrowing advice, Alexander says he is still happy to take the risk the Reserve Bank tightens less rapidly than BNZ is currently forecasting so he would stay floating at a pinch - though it is almost a 50:50 call and nothing one can do will prevent one's rate expense for the next three years being above current floating rates.