MONETARY POLICY Flashcards
how does increasing interest rates cause a contraction of the economy
by increasing interest rates, the costs of borrowing increases which discourages HHs from purchasing big ticket items and consumer durables as the amt they have to pay the bank in interest payments increases. since interest payments HHs receive frm their savings increases, the opp cost of consumption increases making them less likely to consume GAS
by increasing the interest rates, profit-motivated firms ,which make their investment decisions off whether the MB (EROR) of investment is equal or greater than MC (cost of borrowing), invests less as previous profitable units of investment are no longer profitable.
how does poor outlook on the economy affect the effectiveness of monetary policy
firms - when profit motivated firms make investment decisions they consider both the expected ROR and interest rates. with a poor outlook on the economy, it is likely that the expected ROR is likewise low and the chance of business failure is high. despite the low i/r, firms will be hesitant to conduct investments and choose to save.
consumers - with a poor outlook on the economy such as a coming recession, HHs expected to lose their job or suffer a decrease in income. this makes them less likely to borrow and consume big-ticket items like houses and cars but instead choose to engage in precautionary savings
how does the liquidity trap limit the effectiveness of mp
for every economy, nominal interest rates cannot fall below 0 as it would mean creditors are paying borrowers to take on loans. this means that when a country’s i/r are close to 0, they face the liquidity trap as they are no longer able to reduce i/r further to stimulate growth
how does the type of exchange rate limit the effectiveness of mp
if a country is an interest rate taker like Singapore, when they try to decrease i/r independently, it would lead to an increase in short-term capital inflows which increases the demand for loanable funds and exerts an upward pressure on i.r negating the initial decrease in i/r.
how does depreciating a currency lead to an increase in AD
when a country chooses to depreciate its currency, it makes the price of foreign exports increase in terms of domestic currency causing HHs to switch from imports to domestic goods and services. the price of Singaporean exports in terms of foreign currency will decrease, causing the demand for sg exports to increase. if mashall-lerner condition holds then (x-m) will increase. additionally, the price of financial assets for foreigners is cheaper leading to short-term capital inflows and foreign direct investments which increases the demand for loanable funds exerting a upward pressure on interest rates that increases local investments and consumption.
why does exchange rate mp not work
nature of the economy - price of imported inputs —>
spare capacity
