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Unformatted text preview: RANSMISSION MECHANISM
Targeting the monetary aggregates makes sense only if the Federal Reserve can predict what effect these aggregates will have on the economy. The policy–maker needs to know, in other words, the links between money and the objectives of monetary policy. The chain of reactions in the economy that transmits changes in money growth to the levels of unemployment and inflations referred to by economists as the transmission mechanism. We will now broadly outline the mechanism and review this historical evidence on the connection between money growth and the U.S. economy. Consider the results of an open–market purchase of securities. Such a purchase expands total bank reserves, leading to a multiple expansion of loans and investments. The addition to bank credit increases the supply of loanable funds in the economy, thereby putting downward pressure on interest rates in the short run. Since the credit market is highly competitive, all interest rates, not only the rates on securities banks buy or the rates they charge on their loans are reduced.
Dynasty School (www.dynastySchool.com) 2-23 REAL ESTATE FINANCE
Lower interest rates and a greater availability of credit tend to stimulate spending on durable goods of all kinds – on new factories and houses, on business equipment and inventories, and on customer durables such as automobiles. As the rates investors can earn on financial instruments fall, yields on common stocks become more attractive, causing investors to bid their prices up. Households with stocks in their portfolios find that the value of their holdings has gone up, and this increase in their wealth prompts them to increase consumption expenditures. Higher expenditures raise output and employment which, in turn, stimulate business capital–goods spending even further by making greater demands on existing plant capacity. They also boost consumption further because of the income gains that result from the higher level of employment activity. LAGS IN MONETARY POLICY...
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This note was uploaded on 12/30/2010 for the course SOC 101 taught by Professor Zhung during the Spring '10 term at Punjab Engineering College.
- Spring '10