b.Use an aggregate supply and demand diagram (clearly labeled) to demonstrate the effects of a monetary easing when the transmission mechanisms are weak, such as during a deep downturn or when significant financial frictions are present.

i.On the other hand, when transmission mechanisms are weak, financial frictions arise for consumers because transfer of funds to them by financial institutions is impeded. Consumption does not rise as much as it did when credit channels are functioning, shifting AD1 to AD3. This increase in AD is not enough to stabilize the economy. In this case, the economy shifts to point C and still falls short of its long-term equilibrium of point B.

c.Write out the Bank Lending Channel transmission mechanism, and explain how it might break down in situations such as (b). What does this say about the potential effectiveness of monetary policy, post crisis?