Question

Explain how the monetarist transmission mechanism works.

Short answer

The Monetarist Transmission Mechanism works by first manipulating the money supply, which in turn affects the interest rate. Changes in the interest rate influences investment and consumption, which ultimately shift the Aggregate Demand. The shift in Aggregate Demand then impacts output and prices in the economy.

Step-by-step solution

Change in Money Supply

The process begins when the central bank decides to change the money supply. If the central bank wants to stimulate the economy, it will increase the money supply by buying government bonds. Conversely, if the central bank needs to cool down an overheated economy, it will decrease the money supply by selling government bonds.

Impact on Interest Rate

An increase in the money supply will shift the supply of loanable funds to the right, causing the interest rate to fall. Conversely, a decrease in the money supply will shift the supply of loanable funds to the left, raising the interest rate.

Effect on Investment and Consumption

Lower interest rates encourages borrowing and discourage saving, which leads to an increase in consumption and investment spending. On the other hand, higher interest rates discourage borrowing and encourage saving, which leads to a decrease in consumption and investment spending.

Changes in Aggregate Demand

The increase in consumption and investment spending as a result of lower interest rates will shift the Aggregate Demand curve to the right. Conversely, if there is a decrease in consumption and investment spending due to higher interest rates, the Aggregate Demand curve shifts to the left.

Effect on Output and Prices

Finally, an increase in Aggregate Demand will lead to higher output and prices (inflation). Conversely, a decrease in Aggregate Demand will lead to lower output (recession) and lower prices (deflation).