Contractionary and Expansionary Flashcards
What are the pros of contractionary monetary policy?
(ir increase)
Lower inflation.
Demand pull inflation occurs. This can be used to reach the inflation target and cool down the economy.
Discourages household/corporate debt.
Debt is discouraged since its hard to pay it all back. This reduces the risk of bank failure whereby loans may go bad if given to the wrong people.
More sustainable borrowing and lending.
Only those who need to borrow and know they can afford it will be able to do so. This reduces bank failure risks.
Encourages savings.
This is because people can earn an IR of it. This can help cool down the economy.
Reduced current account deficit. High IR will reduce AD meaning lower growth and incomes. This discourages importing.
Flexibility of expansionary monetary policy.
Higher interest rates mean more space for interest rate cuts in the next crisis/problem.
What are the cons of contractionary monetary policy?
(ir increase)
Lower growth and high unemployment shocks.
Shocks can lead to a recession on the demand side, which is bad. Macro objectives tradeoffs involving lower inflation, unemployment, and growth
Impact on indebted. The value of loans/debt will be a lot more. This can lead to bankruptcy, homelessness and more.
Reduced investment.
Its more expensive for firms to borrow so no investment on capital goods.
Worsening of current account deficit.
Higher IR will strengthen the exchange rate since theres hot money inflow through savers wanting to gain a higher return. Also foreign investment. This makes imports cheaper overtime.
What are the cons of expansionary monetary policy?
(ir decrease)
Demand pull inflation.
If IR is cut to reduce unemployment and increase growth, theres a trade of due to higher inflation.
Current account deficit.
If IR is cut this leads to more growth so more incomes. People will be able to afford imports now. Trade off.
Liquidity trap.
Keynesians argue at a given point, reducing IR will not be effective after a given point. At this point, most people have converted unliquid assets into liquid assets. So IR cuts after this point wont see benefits like more consumption and more investment.
Time lags.
It takes time for this to be fully implemented and it takes time to see the full effects. Takes time to go through the transmission mechanism.
Evaluation for expansionary monetary policy.
Size of the output gap.
If the economy is already very close to YFE, any cuts in IR may boost AD but not a lot of growth will be seen.
In a recession, IR have greater potential and effectiveness. Also less inflation here as a trade off.
Dependency on consumers and business confidence.
Reducing IR will only work if these people have confidence in the economy. So in a recession, expansionary monetary policy wont work.
Banks willingness to follow IR cuts.
Banks may not always follow the IR cut shown through the bank rate. They may keep their IR high.
Size of the cut.
For this policy to work, a bigger cut may be better.
