Answer to Question #121245 in Macroeconomics for 120892

Question

Explain in detail the process of Monetary Policy transmission of an increase in the cash interest rate. Use relevant graphs to describe how a Central Bank 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 Central Banks utilizes the monetary policy to manipulate interest rate and money supply in circulation. Through the monetary policy, the Central Bank is able to target the inflation rate. When the inflation rate is high, the Central Bank adopts a contractionary monetary policy so as to lower the money supply. Ideally, this causes the L-M Curve to shift leftwards following a rise in the interest rates since the commercial banks will also be conservative in lending since the money supply in circulation will be limited. 

In the diagram above a shift of the LM curve to the left from LM to LM1 represents a decrease in the money supply. As a result of the shift, the interest rate increases from i to ii while the output level declines from Y to Yi at the new equilibrium level Ei. The Central Bank executes the contractionary monetary policy through open market operations which involve trade of government securities. To lower the money supply, the Central Bank sells the government securities in the open market and as such, money is withdrawn from the flow thereby decreasing money supply. Hence, an increase in the interest rate causes a decline in the money supply and since bank will not be willing to lend, consumers and investors on the other hand will not have money to spend and invest and as such, the money in circulation will decrease consequently lowering the inflation level.