Question

Explain the steps in the policy transmission mechanism (separately) for monetary and fiscal policy, making sure to reference the important role of both the interest elasticity of money demand and the interest elasticity of investment demand in the transmission mechanism.

Answer 1

Well we select expansionary policy which increases AD. Contractionary policy will have exactly opposite effect

Monetary policy=central bank either reduces reserve ratio or discount rate or purchases securities to increase money supply. As a results in the interbank market supply of funds rises. Hence interbank interest rate falls. Since cost of funds to banks fall they decrease their own lending rates. As a result investors and consumers demand more goods since their cost of loans have fallen. The AD will rise more greater the interest elasticity of money demand and investment since then only small change in interest rates will increase AD quite high

2 As far as fiscal policy is concerned Govt increases expenditure and/or reduces taxes. This stimulates demand since tax cut raises disposable income of people and govt expenditure raises demand for goods and services directly as it purchases goods from private sector and pays incomes to those who work in New projects who inturn demand other goods and services. However smaller the interest elasticity of money demand and investment greater the effect of fiscal policy because then crowding out will be quite low