Presently, most countries adopt financial policies in order to improve their economic and social conditions. However, those policies differ as there is not a policy that could be applied for every country. Monetary policy is one of the most widely used ones. The policy is usually implemented by the central bank. It uses an interest rate transmission mechanism in order to achieve its aims. According to Lipsey (2007), one of the main aims of the central bank is to control inflation. Although in theory the monetary policy is likely to succeed, in real life it is not always the case as it was with Japan in 1990s.
The central bank can introduce either expansionary or contractionary monetary policies. Interest rate transmission mechanism is used during both of them. The aim of the expansionary monetary policy is to increase the national income through decreasing the interest rate. Firstly, central bank increases money supply (MS). It can engage in open market operations. For example, central bank can increase MS through buying bonds from the market. Interest rate and demand for money (Md) have negative relationship. Therefore, the more is the interest rate the less is the demand for money. The key reason for that is the opportunity cost of holding money. If the interest rate is high enough consumers are willing to save money. However, if the interest rate is low consumers are likely to spend money on goods and services. Therefore, as MS increases, Md increases as well. As a result, the interest rate decreases. These can be observed on the diagram 1.
The initial equilibrium point is E1 (the intersection of MS1, i1, and Md1). The new equilibrium point is E2. However, it should be mentioned that all other variables are assumed to be unchanged. For example, the price (P) is constant, so P=P ̅. Therefore, all the components are in real terms, not nominal.
Secondly, the decreasing interest rate usually stimulates increasing investment spending. Firms are encouraged to invest more if the interest rate is lower. That is due to the opportunity to earn greater profit. Consequently, firms borrow from the banks and make investment spending. The negative relationship between interest rate and investment spending (I) is shown on diagram 2.
Afterwards, the increase in I affects the national income (nat. Y). It can be identified using aggregate expenditure (E) – national income positive relationship. E is the sum of all spending in economy at current prices. In addition, both E and Y are flows so they are given over period of time (/t). In a closed economy, E includes autonomous consumption (a), investment spending (I), and government spending (G). a is a spending that will be made even without income (usually through borrowing). Furthermore, the consumption function C is equal to a+bY. b is a marginal propensity to consume (0