The transmission mechanism states that monetary policy affects income via the interest rate and investment. It is the procedure by which money supply affects the income. Let us assume that the government follows despicable money. The central bank, for illustration, might reduce the bank rate. This will outcome in a drop in the market rate of interest. Then the investment will mount up. This, in turn, will raise employment and income. The rise in money supply can too caused by variation of cash reserve ratios and open market operations.
Figure: Diagrammatic symbolization of Transmission Mechanism
Figure above illustrates how transmission mechanism works. Part A of the diagram states that whenever there is a fall in the rate of interest from r1 to ro, money supply raises from Mo to M1. As an outcome of the fall in the rate of interest and rise in the supply of money, investment raises from Io to I1 as illustrated in figure above. The increase in investment outcomes in increase in income from Yo to Y1 as illustrated in figure shown above.
Most of the modern economists argue that this view of transmission mechanism is instead narrow. They say that similar to investment, consumption might differ with the interest rate. The classical economists supposed that consumption is inversely associated to the rate of interest. When we accept that view, a fall in the interest rate will cause a raise in consumption. As consumption is a component of aggregate demand, aggregate demand rises. This in turn, will raise the equilibrium level of income. When both consumption and investment rise, income will increase by more amount than when only investment rises.
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