Question

1. Explain transition mechanism for the expansionary monetary policy by using florigen exchange market, bond market, market of money, and AS-Ad model.

Answer 1

The transition mechanism of monetary policy is the process by which asset prices and economic conditions affected due to decisions on monetary policy. There are four main channels which monetary policy enhances the price level and national income. They are interest rate, prices of financial assets, domestic credit and exchange rate.
Foreign exchange market: The expansionary monetary policy having strong impact on exchange rate. Through expansionary monetary policy the money in circulation increased, which leads to reduction of nominal interest rate through increasing the amount of currency in circulation. So there is depreciation in nominal exchange rate. This depreciation of nominal exchange rate results subsequent real depreciation.
Bond market: There is upward pressure on price of financial assets due to expansionary monetary policy. This increase in price of bonds increase the market value of firm and also the value of securities increased. This leads increase in investment and national income and output.
Money market: The demand for money will increase with expansionary monetary policy. With increasing money supply the consumption demand and investment demand will increase more and this will leads to increase in money demand.
AD and AS: The components of aggregate demand are consumption demand, investment demand, government expenditure and export sector expenditure. Through increasing money supply will increase all these components. To maintain balance the supply side will also increased.