Monetary Policy

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What are the strengths of monetary policy?

It is incremental, flexible, easily reversible, and can be implemented quickly by the central bank.

What diagram illustrates the effect of expansionary monetary policy?

AD/AS diagram showing a rightward shift of the AD curve to close a deflationary gap.

What diagram illustrates the effect of contractionary monetary policy?

AD/AS diagram showing a leftward shift of the AD curve to close an inflationary gap.

What is a limitation of monetary policy during a recession?

Low consumer and business confidence may reduce the effectiveness of lower interest rates in stimulating spending.

What is monetary policy?

The control of money supply and interest rates by the central bank to influence aggregate demand and achieve economic objectives.

How does monetary policy affect business cycle fluctuations?

It helps smooth economic fluctuations by stimulating demand during recessions and reducing demand during booms.

Why does monetary policy face time lags?

Because it takes time for interest rate changes to influence spending and investment decisions.

How does lowering interest rates affect aggregate demand?

It encourages borrowing and investment, increases consumption, and reduces saving, boosting aggregate demand.

What does inflation targeting involve?

A central bank setting an explicit inflation rate target and adjusting policy instruments to achieve it.

What is an expansionary monetary policy?

A policy aimed at increasing aggregate demand through lower interest rates and increased money supply to close a deflationary gap.

What is meant by external balance as a goal of monetary policy?

Maintaining stability in the balance of payments to avoid large current account deficits or surpluses.

What are two constraints on monetary policy effectiveness?

Limited impact when interest rates are near zero and low confidence among consumers and businesses.

What is the liquidity trap?

A situation where interest rates are close to zero and cannot be reduced further, making monetary policy ineffective.

What is a contractionary monetary policy?

A policy aimed at reducing aggregate demand by raising interest rates and decreasing money supply to control inflation.

Calculate the real interest rate if the nominal rate is 5% and inflation is 2%.

Real interest rate = 5% - 2% = 3%.

What is the difference between nominal and real interest rates?

Nominal rates are unadjusted for inflation, while real rates account for inflation by subtracting the inflation rate from the nominal rate.

How does monetary policy help maintain low unemployment?

By stimulating aggregate demand through lower interest rates and increased money supply during economic downturns.

What happens to aggregate demand if the central bank raises interest rates?

Aggregate demand decreases because borrowing costs rise, consumption and investment fall.

What are the main goals of monetary policy?

Low and stable inflation, low unemployment, reduced business cycle fluctuations, stable economic environment, and external balance.

Why is maintaining a low and stable inflation rate important?

It preserves purchasing power, reduces uncertainty, and encourages investment and economic stability.

Monetary Policy in the News