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In chapter 25 we see the process of how monetary policy affects the overall economy. The transmission mechanisms show the variables that change when the Fed takes action. Without identifying the 9 channels by name, identify the variables that change when the Fed initiates policy. Then explain how changes in these variables affect aggregate demand. Finally, explain what happens to real GDP. Look at this as a chain reaction. In your answer assume the Fed initiates an expansionary monetary policy action.

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Chapter 25 Transmission Mechanisms (Channels) of Monetary Policy Preview • This chapter examines the transmission mechanisms of monetary policy and evaluates the empirical evidence on them to better understand the role that monetary policy plays in the economy. Figure 1 The Link Between Monetary Policy and Aggregate Demand: Monetary Transmission Mechanisms 1) The Traditional Real interest rates are important • • • • Real interest rate declines…… Investment increases….. Consumption increases….. AD increases to right Real GDP Increases 2) Exchange Rate Effects on NX • • • • • • • Real interest rate declines…… Causes investment to move out of US…. Supply of $s in world mkt increases….. Demand for dollars decreases…. Exchange rate falls ($ depreciates)….. NX increases…….. AD increases to the right Real GDP increases 3) Tobin’s q Theory • • • • • • Real interest rate declines…… Stock prices increase…… q increases(q=mkt value of firms/replacement cost of capital) Firms are motivated to issue more stock… Investment increases……. AD increases to the right Real GDP increases 4) Wealth Effects • • • • Real interest rate declines…… Price of stock increases….. Wealth increases people are richer…… Long term: For every $1 increase in wealth, spending increases from 3 to 7 cents • Consumption increases….. • AD increases to the right Real GDP increases 5) Bank Lending Channel • • • • • • Focuses on volume of loans not interest Bank reserves increase….. Bank deposits increase….. Bank loans increase….. Investment increases….. AD increases to the right real GDP increases. • Small business most effected here 6) Balance Sheet Channel • • • • • • • • Real interest rate declines…… Price of stock increases….. Firms net worth increases….. Adverse selection and moral hazard decrease…… Easier to get loans…. Lending increases….. Investment increases….. AD increases to the right Real GDP increases 7) Cash Flow Channel • Nominal interest rates decrease….. • Improves business cash flow….. • Increases number of better qualified borrowers • Adverse selection and moral hazard decrease…… • Lending increases….. • Investment increases….. • AD increases to the right Real GDP increases 8) Unanticipated Price Level Channel • • • • • • Real interest rates decrease…… Inflation increases…. Unanticipated prices increase…… Real value of debt declines….. Firms real net worth increases….. Adverse selection and moral hazard decrease…… • Lending increases…. • Investment increases • AD increases to the right 9) Household Liquidity Effects • • • • Real interest rates decrease…… Price of stock increases…. Value of HH financial assets increase…. Likelihood of financial distress decreases… • Consumer durable and housing expenditure increases…… • AD increases to the right real GDP increases
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Running head: AN EXPANSIONARY MONETARY POLICY ACTION

Discussion Post: An Expansionary Monetary Policy Action
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AN EXPANSIONARY MONETARY POLICY ACTION

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Discussion Post: An Expansionary Monetary Policy Action
In the economic circles, expansionary monetary policy action is perceived to be the
government’s approach of increasing employment; however, when defined expansionary
monetary policy action refers to the process of ...


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