Question

Explain 4 Monetary Transmission Mechanisms (Channels of money) and explain how reductions in money impact the components of aggregate demand, AD and output

Answer 1

Monetary mechanisms that causes reduction in money supply in economy are as follows :-

1). Increase in bank rate :- An increase in bank rate raises the market rate of interest and as a result credit becomes costly. Accordingly, availability of credit (money supply) reduces in an economy, thereby, causing reduction in output level and aggregate demand (AD) in economy.

2). Open market operations :- Open market operations refer to the purchase and sale of government securities in the open market by the central bank. By selling the government securities, the central bank withdraws the additional purchasing power from the economy system which results in the contraction (fall) of credit (money supply), thereby, resulting in fall in level of output and aggregate demand (AD) in an economy.

3). Increasing Cash reserve ratio (CRR):- With a view to restricts flow of credit (money supply), Central bank increases Cash reserve ratio (CRR). As a result, aggregate demand is reduced and Output level also decreased in an economy.

4). Increasing Statutory liquidity ratio (SLR):- With a view to restricts flow of credit (money supply), Central bank increases Statutory liquidity ratio (SLR). As a result, aggregate demand as well as Output level are reduced in an economy.