Question

Discuss the mechanisms through which monetary policy affects stock prices and aggregate demand. Please be specific about the channels/theories.                                                             

Answer 1

Monetary policy tends to change money supply in the economy. Fed can raise money supply by expansionary monetary policy while they can reduce it by contractionary monetary policy.

A rise in money supply gives more cash to people in hand which raises their willingness to pay of goods. With rise in willingness to pay, they tends to consume more of the goods which raises aggregate demand in the market. It shifts aggregate demand to its right. It raises price as well as output level in the economy.

A rightward shift in aggregate demand will shift IS curve to its right which will raise rate of interest from "i" to "i1" in the economy.

A rise in rate of interest will raise cost of borrowing for multinational firms which holds a greater share in stock market. They tends to issue more stocks in the market to generate more funds to cover the extra cost of borrowing. Thus we can observe that expansionary monetary policy will raise the supply of stocks which will reduce its price.