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Three components of the transmission mechanism,through which the expansionary policy works - Essay Example

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An expansionary monetary policy works by increasing the supply of money available in the economy.The recessionary gap is handled by the corresponding increase in demand which tends to create employment in the shorter run. …
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Three components of the transmission mechanism,through which the expansionary policy works
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Download file to see previous pages An expansionary monetary policy works by increasing the supply of money available in the economy.The recessionary gap is handled by the corresponding increase in demand which tends to create employment in the shorter run. As soon as the economy is supplied with money, the aggregate demand level rises from its previous state as shown in Figure 1 below. The demand level tends to rise from the existing AD1 level to a new AD2 level. In turn this increase in demand triggers an increase in the price level which tends to rise from an existing level of P1 to P2 which can be seen as inflation (Mankiw, Kneebone and McKenzie 503). As a consequence of price hikes, the inflation rate tends to increase as shown in Figure 2 and Figure 3 below. The short term Phillips Curve shows a linear increase as the amount of inflation rises but the long term Phillips Curve shows a vertical increase as the aggregate demand rises. If money is supplied to the economy at a fast rate, the outcome would be a small change in the overall employment rate since inflationary pressure would curb the economic growth. In contrast, if money is supplied to the economy relatively slowly, there would be a smaller increase in overall inflation and hence the net employment gain would be greater. In order to control a recessionary gap, the government has to offer the economy greater liquidity by increasing the supply of money. However, it must be kept in mind that the rate of supply of money has to be relatively low so that long term inflationary pressures do not set in. ...
Fiscal policy can be controlled by increasing or decreasing government spending as well as by manipulating the taxation levels of ordinary households. A contractionary fiscal policy reduces the supply of money to the economy. When the supply of money to the economy decreases, the aggregate demand reduces from its existing level to a lower level. This leads to a contraction of the aggregate demand which in turn reduces the overall output levels in the economy. Consequently, the contractionary fiscal policy moves the economy along the short run Phillips curve as shown in Figure 4 below. In the longer run, the economy shifts vertically along the Phillips curve which leads to a reduction in the overall inflation rate with a minimal effect on the overall employment levels (Mankiw, Kneebone and McKenzie 512). Figure 4 - Disinflationary monetary policy in the short run and long run When the amount of government spending tends to increase, it increases the overall money supply in the economy. As a result, the demand for money in the economy tends to rise from MD1 to MD2 as shown in Figure 5. Consequently, the interest rate tends to rise which leads to a net reduction in the investment levels and puts reduction pressure on aggregate demand. The aggregate demand level tends to rise though it fails to meet its expected level of increase. While the expected level of increase in the aggregate demand curve should be from AD1 to AD2 but it actually increases only to aggregate demand levels between actual level and expected level to AD3 as shown in Figure 6. The reduction of the aggregate demand as soon as a fiscal expansion takes place is better known as the crowding out effect (Mankiw, Kneebone and McKenzie 487). Figure 5 - The money market Figure 6 - Changes in ...Download file to see next pagesRead More
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