The Transmission Mechanism

The mechanism by which the changes in monetary policy affect aggregate demand is called 'transmission mechanism'. Two stages in transmission mechanism are important. First is that an increase in real money supply causes a portfolio disequilibrium at the prevailing interest rate and level of income, i.e. people are holding more money than they want. They try to get rid of the excess money they are holding by buying financial assets. This action of theirs pushes up the price of financial assets and thus causes the interest rate to fall.

The second stage of the transmission process occurs when the change in interest rate affects aggregate demand. The fall in interest rates induces an increase in investment expenditure, and also possibly consumption expenditure, thereby increasing the aggregate demand and ultimately the income.