Question

2. Explain transition mechanism for the expansionary monetary policy by using florigen exchange market, bond market, market of money, and AS-Ad model.

Answer 1

Ans. An expansionary monetary policy will increase the money supply shifting money supply curve rightwards from Ms to Ms' creating excess supply of money in the market. This will increase the demand for bonds in the bond market shifting the demand curve for bonds from Bd to Bd' which will increase the peice of the bonds from Bp to Bp'. As bond price and interest rate are negatively related, so, increase in price of bonds decreases the interest rate in the market from r to r'. This decrease in interest rate decreases cost of borrowing increasing the investment and consumption spending in the market. Also, decrease in interest rate will increase the net capital outflow from the country which will lead to increase in demand of foreign currency shifting the demand curve for foreign currency rightwards from Fe to Fe'. This leads to increase in the exchange rate from e to e' i.e. depreciation of domestic currency which makes exports cheaper and imports expensive increasing demand for the former and decreasing demand for the latter. This increased the net exports. So, increase in net exports and investment and consumption spending increases aggregate demand for goods and services shifting the aggregate demand curve rightwards from AD to AD' leading to increase in price level from P to P' and equilibrium output from Y to Y'.

price levela phence of bonds "AS BS BB Bp De •Bd' AD AD Output ad Quantity I bonds pinterest rate ? MS MS t exchange rate Es J2 e Md L L" Quantity of Quantity I money FF bunga curricy

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