Question

Explain in detail the process of Monetary Policy transmission of a decrease in the cash interest rate. Use relevant graphs to describe how a Central Bank’s action on the interest cash rate ripple through the economy and lead to the target policy goal. (Three connected diagrams should be used: (1) money supply and demand (2) investment demand schedule (3) AS/AD diagram. Interest rates is the variable that connects the first and second diagram).

Answer 1

The RBI or the central bank uses the monetary policies for manipulating the interest rates and the supply of money in the market. The Central bank controls inflation through monetary policy. When there is a decrease in the interest rate, the money supply will be increased and the demand increases and thus the inflation increases. This monetary policy is called the expansionary monetary policy which stimulated the economy. The expansionary monetary policy expands and triggers economic growth. The value of currency will be reduce and the exchange rate would be decreased too. In this IS LM model, the expansionary monetary policy, ie increase in money supply shifts the LM curve to right. This causes the GDP to rise and interest rates to fall. This can be shown in the following diagram.

The expansionary monetary policy has a positive impact initially as the Y is increasing from Y0 to Y1. The increase in supply of money has caused the interest rates to fall and inorder to restore the money market equilibrium on the goods market side. The decreased interest rates is leads to increase in investment spending which increases the national income.