Answer to Question #143255 in Microeconomics for mbali

Question

Explain, with the aid of graph(s), the monetary transmission mechanism of an increase in the repo rate. You are required to illustrate and explain all the components of the monetary transmission mechanism

Answer 1

Increase in the repo rate is immediately transmitted to other short-term money-market rates, both to money-market instruments of different maturity and interbank deposits. As a result the interest rates that banks charge their customers increase too.

Thus the cost of capital is affected, causing a decline in investment spending (I) and consumer spending I, leading to a decline in aggregate demand and real output (y).