Answer to Question #137280 in Macroeconomics for Puspa Pokharel

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

$$Solution$$

Increase in cash rate reduces the amount of money supply in the economy. The amount of money supplied in the economy and this increases the rate of interest in the money market. An increase in the rate of interest will reduce investment demand in panel $ii$. As investment demand reduces, aggregate demand reduces to to $AD'$ and hence new equilibrium point at $E_2$, price level and real GDP decreases in the economy. This is shown in the graphs below.