Question

What are the three channels of monetary policy? Explain each of these in detail. Also explain under what conditions monetary expansion fail to affect aggregate demand for goods and services in the short run and long run.

Answer 1

Three channels of monetary policy are

* Interest rates - Government tries to control monetary policy through changes in interest rates . An increase in interest rate will encourage people to save more and spend less . Thus increased savings will reduce money supply.

* Exchange rate - Exchange rate is rate at which country trade with each other . Central banks intervenes in foreign exchange market to control movement of currency so that it doesn't move out of bounds. Central Bank by buying and selling foreign and domestic currency tries to control the money supply.

* Lending activities- Central banks by increased lending can increase or decrease the level of money supply in economy.

In the case of liquidity trap monetary policy is ineffective in both short run as well as in long run.

Liquidity trap is a condition in which interest rates are so low that changes in money supply didn't have any affect on output level .