Let us now see how monetary policy works, i.e., how it affects aggregate demand, GDP and the price level.

Monetary policy works through what is called the transmission mechanism.

Transmission mechanism is the mechanism by which changes in monetary policy affect aggregate demand. The transmission mechanism works in two stages.

In stage one, changes in interest rates affect investment expenditure.
In stage two, changes in investment affect aggregate demand.

Stage One : Investment Demand Function

Investment demand bears an inverse functional relation with the interest rate. Other things being equal, a decrease in the rate of interest makes borrowing cheaper and generates new investment expenditure.

The link between the interest rate and the investment expenditure is shown in


is drawn in two panels. Panel (a) shown money demand  and supply.

The original interest rate is r₁; at this interest rate quantity demanded and supplied of money is equal at M₁.

Suppose the monetary authority decided to reduce the interest rate to r₂. They will have to buy all the extra bonds offered for sale at the new reduced interest rate; money supply in the economy will increase to M₂. Market will be in equilibrium at the lower interest rate at r₂.

Panel shows the investment function. At the original interest rate, r₁, investment expenditure amounted to I₁. Now, with more money available in the economy and lower interest rates, investment expenditure increases to I₂. By joining points A and B, we get the investment demand function. The investment demand function demonstrates the inverse relation between interest rate and investment expenditure.

An increase in investment expenditure at a lower interest rate would result in an increase in the aggregate expenditure, and thus the aggregate demand curve will shift upwards. A new equilibrium will come to be established at a higher level of income.

This can be illustrated with the help.


After a fall in the rate of interest from r₁ to r₂ as shown in investment expenditure raises by ΔI, and as a result, aggregate expenditure curve AE₁ shifts upwards to AE₀, as shown in (a). Given the price level P₀, the equilibrium point shifts from E₀ to E₁ causing a rise in GDP from Y₀ toY₁. In at the given price level P₀, equilibrium is shown by point R₀. Where at the aggregate demand curve AD₀, the GDP IS Y₀.

An increase in the investment expenditure by ΔI, equilibrium point shifts upwards from E₀ to E₁ and real GDP rises from Y₀ to Y₁, as shown in price level remaining unchanged at P₀, a shift in aggregate expenditure curve AE₀ to AE₁ causes a rightward shift in the aggregate demand curve AD₀ to AD₁, as shown in. At the new equilibrium point R₁, the real GDP rises from Y₀ to Y₁.

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