Answer to Question #204385 in Macroeconomics for gurpreet

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’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

Higher cash rate tends to minimize money supply within the economy. Money supplied within an economy raises interest rates in the market. The increased rate minimizes investment demand. As it gets reduced, aggregate demand tend to be reduced towards AD¹, which brings E₂ as the new point of equilibrium, and real GDP and price level similarly reduces within the economy. This is displayed in the graphs below.

Central bank normally use monetary policy in manipulating the rate of interest and Supply of money within the circulation. Based on monetary policy, Central Bank can focus on the inflation rate. If the rate of inflation is high, Central bank usually adopt a polity to minimize money supply. This makes L-M Curve shifting leftwards based on the higher interest rates, as commercial Bank will have to be conservative in terms of lending cash. This is because the circulation's supply tends to be limited.