Question

Describe the Second Transmission Mechanism involving the Federal Reserve, Freddie Mac and Fannie Mae and how the U.S. money supply increases through this mechanism?

Answer 1

The first stage of the transmission mechanism is the financial system channel. There, monetary policy actions are primarily manifested by changes in shortand long-term interest rates, asset prices, liquidity and the exchange rate of domestic currency.

The second stage of the transmission mechanism describes the impact of monetary policy from the financial system and onto the rest of the economy, i.e. how central bank interest rate decisions affect spending decisions by individuals and firms. In turn, these decisions affect aggregate demand and ultimately the rate of inflation.

Suppose a monetary policy action is taken that changes the interest rate for the short term. The short-term interest rate change in turn has an effect both on the exchange rate and on the long-term interest rate. Of course, one should remember that the short-term interest rate is just one of many factors that affect the exchange rate and the long-term interest rate; and the effects of the short-term interest rate on both are uncertain and variable over time.

In any event, given the rigidity of the economy, changes in nominal exchange rate and interest rates influence actual exchange rates and real interest rates. Real rate shifts would have a short-run effect on real net exports, real demand, real spending and thereby on real GDP. However, in the short term, incomes and the costs of commodities continue to change and, as they do, real GDP returns to normal. In the long run the real interest rate and real exchange rate return to their fundamental levels.

By influencing interest rates, prices of assets and the exchange rate of the domestic currency and the amount of money, monetary policy has an effect on the behavior of individuals through different channels. One of those
The most significant monetary policy effects are possibly through disposable income.

Monetary policy also has an impact on the timing of consumer decisions, as interest rates in effect represent the price of current consumption relative to future prices. As interest rates increase, current spending, i.e. current investment, becomes more costly relative to future consumption. Therefore individuals should reduce their existing consumption by a proportional volume.

Monetary policy can also affect the consumption expenditure of individuals through consumers’ expectations about their future income and employment prospects. A tighter monetary policy could be interpreted as signalling that the rate of economic growth is faster than had been thought. Individuals’ expectations could thereby be kindled, and likewise their willingness to spend.

Consequently the effect of monetary policy is communicated across a wide variety of networks to the purchasing decisions of individuals. In general a increase in the policy rate of the central bank would cause a reduction in individuals' overall spending. We will also continue to transfer their spending from domestic to foreign goods in response to the impact of exchange rates which makes imports relatively cheaper.

The extent of the effect of monetary policy on individuals’ expenditure decisions, and even sometimes on the direction they take, may vary from one time to another, depending upon factors such as its effect on individuals’ expectations and confidence.

Monetary policy also affects the decisions made by firms about spending through interest rates, asset prices , exchange rates and the amount of money. This effect can vary depending on the nature of the business, the size of the firm and its financing sources.

Monetary policy also affects capital costs by their temporary impact on real long-term interest rates. So a rise in the rate of policy should also prompt a temporary increase in the required return on new projects , making companies more likely to postpone or simply abandon those plans.

Monetary policy has effects on corporations' confidence and expectations about the economic outlook, just as it does for individuals. This may be a crucial factor , especially for irreversible in the long term
Investments. Expectations about future sales, interest rate developments and future risk play a major role in the timing of investments.