Monetary Policy- Problems and Evaluation

Question 1

What is the main aim of cutting interest rates?

Answer 1

To stimulate aggregate demand (AD) by encouraging consumption and investment.

Question 2

What is demand-pull inflation?

Answer 2

Inflation caused by excessive growth in AD, where demand outpaces supply.

Question 3

Why might cutting interest rates cause demand-pull inflation?

Answer 3

Lower rates boost consumption and investment, shifting AD rightward (e.g., from AD₁ to AD₂), potentially overshooting the inflation target.

Question 4

What are the risks of overshooting inflation targets?

Answer 4

Price instability, reduced purchasing power, and erosion of confidence in monetary policy.

Question 5

How does this appear on an AD/AS diagram?

Answer 5

Expansionary policy shifts AD right (AD₁ → AD₂). If the economy is near full capacity (Y₁ → Y₂), output rises slightly, but price level rises significantly (P₁ → P₂).

Question 6

What is a second key downside of cutting interest rates?

Answer 6

A worsening current account due to increased imports (from higher domestic income and consumption).

Question 7

Why do imports rise with lower interest rates?

Answer 7

Incomes rise → higher consumer spending → increased demand for imports → larger current account deficit.

Question 8

Define a macroeconomic trade-off.

Answer 8

A situation where achieving one policy objective leads to worse outcomes in another (e.g., growth vs inflation or growth vs external balance).

Question 9

What are examples of macroeconomic trade-offs in this context?

Answer 9

Stimulating growth (lower unemployment) may worsen inflation and the current account deficit.

Question 10

What’s a situational evaluation of cutting interest rates?

Answer 10

Effectiveness depends on consumer/business confidence, existing level of debt, or whether the economy is in a liquidity trap.

Question 11

What is a liquidity trap?

Answer 11

A situation where interest rates are so low that monetary policy becomes ineffective in stimulating demand.

Question 12

Why is monetary policy ineffective in a liquidity trap?

Answer 12

Consumers and firms already hold large cash balances and are unwilling to borrow or invest, even if rates are cut further.

Question 13

What is the Keynesian argument about the lower bound of interest rates?

Answer 13

Interest rates cannot fall below a certain point (zero or slightly negative), beyond which rate cuts do not increase spending or investment.

Question 14

What is the real interest rate, and why does it matter for savers?

Answer 14

Real interest rate = Nominal interest rate - Inflation. If inflation is higher than the nominal rate, savers earn negative real returns.

Question 15

What is the impact of low or negative real interest rates on savers?

Answer 15

Savers lose purchasing power, leading to reduced income and possibly a fall in living standards, especially for pensioners or fixed-income groups.

Question 16

What behavioural effects can low interest rates have on savers?

Answer 16

Reduced incentive to save and increased incentive to borrow and spend — but this can backfire if people feel financially insecure.

Question 17

How could reduced savings harm the economy?

Answer 17

Lower savings can reduce the funds available for investment and increase vulnerability during financial shocks (e.g. job loss).

Question 18

Why might consumers still not spend during periods of low interest rates?

Answer 18

Due to uncertainty, low confidence, or fears about future income, people might prefer to hoard cash rather than spend.

Question 19

What is the central bank’s dilemma in a liquidity trap?

Answer 19

Cutting interest rates further won’t increase AD, leaving the central bank with limited options (e.g. needing to resort to fiscal policy or QE).

Question 20

What is a key evaluation point for interest rate policy?

Answer 20

Its effectiveness depends on the economic context — e.g. confidence, liquidity preference, income levels, and whether the economy is near the zero lower bound.

Question 21

What is the time lag in monetary policy?

Answer 21

Interest rate changes take time to affect AD — typically 12 to 18 months through the transmission mechanism.

Question 22

Why do interest rate changes take so long to affect the economy?

Answer 22

It takes time for lower borrowing costs to influence consumer and business decisions, and for those decisions to impact output and employment.

Question 23

How does the size of the output gap affect the effectiveness of interest rate cuts?

Answer 23

Large negative output gap: Interest rate cuts are more effective; there’s room to grow without triggering inflation.
Small or positive output gap (near full employment): Rate cuts risk causing demand-pull inflation with limited gains in output or jobs.

Question 24

Why is consumer confidence important for monetary policy?

Answer 24

If consumers fear job losses or economic uncertainty, they may not increase spending even if interest rates fall.

Question 25

What happens if consumer confidence is low during a rate cut?

Answer 25

The marginal propensity to consume may stay low — consumers may save more rather than spend, making the policy ineffective.

Question 26

Why is business confidence crucial for interest rate policy to work?

Answer 26

Businesses will only invest when confident in future demand and stability. Low confidence = low investment, even with cheap borrowing.

Question 27

What is an evaluation point related to the state of the economy?

Answer 27

Monetary policy is context-dependent — more effective in recession with spare capacity than in a boom with high inflation risk.

Question 28

How can interest rate cuts interact with other policy tools?

Answer 28

On their own, rate cuts may be insufficient. May need to be combined with fiscal policy or quantitative easing in a downturn.

Question 29

What's a trade-off when using interest rate cuts to stimulate growth?

Answer 29

You may reduce unemployment but risk worsening inflation and the current account balance — classic macroeconomic trade-offs.

Question 30

Can interest rate cuts always control inflation?

Answer 30

No — they may be less effective in a cost-push inflation scenario, where prices rise due to supply-side factors like oil shocks.

Question 31

How do expectations about future profitability influence investment?

Answer 31

If firms expect strong future profits, they're more likely to invest when interest rates fall. Low confidence can block this effect.

Question 32

Why might a fall in interest rates not increase investment?

Answer 32

If business confidence is low, firms may not borrow or invest regardless of lower costs of finance.

Question 33

How does bank willingness to lend affect monetary policy?

Answer 33

If banks are risk-averse or facing financial stress (e.g. during a credit crunch), they may not lend, making rate cuts ineffective.

Question 34

What is meant by “passing on the rate cut”?

Answer 34

Banks need to reduce their own lending rates in line with the base rate. If they don’t, borrowers won't feel the impact.

Question 35

Why might banks not pass on rate cuts?

Answer 35

Due to concerns about their balance sheets, default risk, or funding costs — especially in a financial crisis.

Question 36

How does the size of the interest rate cut affect its impact?

Answer 36

Larger cuts have a stronger effect on AD by more significantly reducing borrowing costs and increasing incentives to spend/invest.

Question 37

Why might a small interest rate cut be ineffective?

Answer 37

It may not be enough to shift consumer or business behavior, especially if confidence is low or the cost difference is minimal.

Question 38

What’s a compound evaluation point for interest rate effectiveness?

Answer 38

Even if rates fall, policy effectiveness depends on multiple links in the transmission mechanism — confidence, lending, time lags, and economic slack.

Question 39

In what situation might monetary policy be completely ineffective?

Answer 39

In a liquidity trap or during a banking crisis, where rate cuts fail to stimulate borrowing, spending, or investment.

Question 40

What alternative policies might be needed if interest rates are ineffective?

Answer 40

Fiscal policy (government spending/tax cuts), quantitative easing, or structural reforms to boost confidence and productivity.