Question

2. Describe the Keynesian transmission mechanism for a decrease in the money supply. Assuming that no liquidity trap exists, that investment is interest-sensitive, and that the economy is in the horizontal portion of the AS curve, what happens to Real GDP and the price level? How can you tell if this is a direct transmission mechanism or an indirect one?

Answer 1

The Keynasian Transmission mechanism for a decrease in the money supply occurs in three steps -

First, there is a decrease in money which leads to a risein interest rate as competiton for lonable funds tightens up.

Second, the rise in interest rates, makes borrowing costlier. Some investment become less profitable and crowd out. Investment spending falls.

Finally, a fall in investment causes aggregate spending to fall. This results in a greater decrease in output through the multiplier effect.

Based on the given conditions, there is a horizontal AS curve. This means that we are in the very short run/Keynasian zone of AS curve. This is so because of the supply being perfectly price elastic. This can be attributed to the fact that wages are completely rigid and prices do not adjust at all. So due to decrease in money supply, AD decreases and shifts to the left from AD1 to AD2. This causes output to fall from Y1 to Y2 with no change in price. Real GDP falls. Prices are unchanged.

The transmission mechanism is indirect here because change in money supply impacts aggregate demand through interest rates.