In the Monetary policy transmission mechanism, explain what could go wrong between the following points
1. Change in the monetary policy and Change in the money supply
2. Change in the money supply and Change in the aggregate demand curve
Change in the aggregate demand curve and Change in prices, real GDP, and employment
Im not exactly sure what you are asking. So, my response will be rather general in nature.
Monetary policy consists of the things the Federal Reserve can do. Ask yourself, what are these things?
The Fed can 1) change reserve requirements, 2) change the discount rate, or 3) it can engage in open market purchases and sales of government securities. Each of these can have both indended and unintended consequences, or in certain circumstances, have no effect at all. For example, as Keynes argued, if the economy is in a liquidity trap, increasing the money supply will have no effect on aggregate demand.
I suggest you start with a standard IS/LM model. Draw several extreme scenarios (e.g., a liquidity trap where the LM line is flat, or full employment where the IS curve is vertical. The apply a monetary policy and see what happens to interest rates, and real GDP, etc.
Lotsa luck
Between the points of change in the monetary policy and change in the money supply, several things can go wrong. Here are a few potential issues:
1. Ineffective policy implementation: When the monetary policy changes, the intended impact on the money supply may not materialize due to various factors. For example, if banks are hesitant to lend or if consumer and investor sentiment is low, the changes in the policy may not translate into changes in the money supply.
2. Lack of transmission to lending rates: Even if the money supply increases, it does not guarantee that lending rates will decrease. Banks may choose to maintain higher lending rates due to increased risk perception or higher operational costs. This can limit the impact of monetary policy on aggregate demand.
3. Inadequate credit demand: Even if there is an increase in the money supply and lower lending rates, businesses and individuals may not have sufficient credit demand. This can occur during periods of economic uncertainty or when there are limited profitable investment opportunities. In such cases, the change in the money supply might not lead to a substantial change in the aggregate demand curve.
Moving on to the second point between change in the money supply and change in the aggregate demand curve, some potential issues include:
1. Weak effect on consumption and investment: An increase in the money supply does not necessarily guarantee a proportional increase in consumption and investment. Consumer and business behavior is influenced by various factors such as income expectations, confidence, and borrowing costs. If these factors remain unfavorable, the change in the money supply might not have a significant impact on aggregate demand.
2. Crowding out effect: If the increase in the money supply leads to higher government borrowing, it can result in an increase in interest rates and crowd out private investment. This can limit the impact of the change in the money supply on the aggregate demand curve.
Finally, between the change in the aggregate demand curve and change in prices, real GDP, and employment, the following issues can occur:
1. Inflationary pressures: As aggregate demand increases, it can lead to inflationary pressures in the economy. When demand exceeds the available supply, businesses may increase prices to maximize profits, leading to inflation. This can impact the purchasing power of consumers and potentially reduce real GDP.
2. Supply constraints: If the increase in aggregate demand is not matched with an increase in the capacity to produce goods and services, it can lead to supply constraints. In this case, businesses may struggle to meet the rising demand, resulting in higher prices, limited economic growth, and potential job losses.
3. Lack of job creation: While an increase in aggregate demand can lead to economic growth, it does not guarantee job creation. Businesses may choose to maintain or increase production levels without significantly increasing the workforce, leading to limited improvement in employment levels.
It is important to note that the specific outcomes can vary depending on the economic context and the effectiveness of policy measures.
In the Monetary Policy transmission mechanism, there are several points where things could go wrong. Let's explore each of these points:
1. Change in the monetary policy and Change in the money supply:
When the central bank implements a change in monetary policy, such as lowering or raising interest rates, the primary objective is to influence the money supply. However, several factors could complicate this transmission. For instance:
- If commercial banks choose not to pass on the changes in interest rates to borrowers and depositors, the impact on the money supply may be limited.
- If the demand for credit is low, despite lower interest rates, banks may reduce lending, resulting in a limited expansion of the money supply.
To understand the impact, one could analyze the Money Multiplier theory. Start by examining the reserve requirement (RR) and the excess reserves (ER). By calculating the Money Multiplier (MM), you can see how the initial change in the monetary policy affects the final change in the money supply.
2. Change in the money supply and Change in the aggregate demand curve:
The change in the money supply affects the aggregate demand (AD) through various channels like investment, consumption, and net exports. However, there are scenarios where the transmission may not occur as expected:
- If individuals and businesses choose to hoard money rather than spending or investing, the increase in money supply may not have a significant impact on aggregate demand.
- If there is a lack of confidence in the economy or uncertain future prospects, individuals and businesses may reduce spending despite the increase in money supply.
To evaluate the impact, you can use the aggregate demand and supply model (AD-AS model). By analyzing the shifts in the AD curve resulting from changes in the money supply, you can see how it affects real GDP and prices.
3. Change in the aggregate demand curve and Change in prices, real GDP, and employment:
Changes in aggregate demand can affect prices, real GDP, and employment. However, complications can arise due to various factors:
- Price rigidities and contracts may prevent immediate adjustments to changes in aggregate demand. In the short run, prices may not respond as expected.
- If production capacities are already close to their limits or if there are supply bottlenecks, an increase in aggregate demand may result in inflation rather than increased output.
- Changes in the aggregate demand might not have a significant impact on employment if there are other structural factors affecting the labor market, such as skill mismatches or barriers to mobility.
To analyze the impact, one can examine the aggregate demand and supply model alongside concepts like the Phillips curve and Okun's law. By considering factors affecting prices, real GDP, and employment, you can better understand the potential outcomes of changes in the aggregate demand curve.
In summary, understanding the Monetary Policy transmission mechanism requires analyzing the various factors and channels through which changes in monetary policy, money supply, and aggregate demand can affect the broader economy. By considering these complexities, you can identify potential complications and better understand the outcomes of specific policy actions.