Question

The process of how monetary policy affects the overall economy. The transmission mechanisms show the variables that change when the Fed takes action. Without identifying the 9 channels by name, identify the variables that change when the Fed initiates policy. Then explain how changes in these variables affect aggregate demand. Finally, explain what happens to real GDP. Look at this as a chain reaction. In your answer assume the Fed initiates an expansionary monetary policy action.

Answer 1

Ans)- If fed initiate Expansionary Monetary policy action then,-

Fed conduct monetary policy mainly through open market operations, which states the sale or purchase of govt. securities i.e. govt. treasuries, govt. bonds etc.

In expansionary monetary policy, Fed increases the money supply in the economy by purchasing govt. securities in exchange of money.

Monetary policy works through transmission mechanism. It is a process by which changes in monetary policy affects AD & thereby output level and income level.

It has two steps-

a) In the first step of transmission mechanism, increase in real money supply generates portfolio disequilibrium. It means at existing interest rate & level of income, people are holding more money than than they want. This causes portfolio holder to attempt to reduce their money holding by purchasing otherv assets like bonds. As a result, price of bonds increases and rate of interest decreases.(this was the affect of increased money supply in money market).

b) In the second step of transmission mechanism, change in interest rate affects Aggregate demand i.e. decrease in interest rate increases Investment in the goods market and thus increase in investment increases Aggregate demand ( AD = C+I+G+NX). Due to this, output (real GDP) level in the economy also increases with increase in AD (at equilibrium, Y = AD).