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Exam: Dec. 2014 Level 1 > Study Session 5. Economics: Macroeconomic Analysis > Reading 19. Monetary and Fiscal Policy > Subject 6. Contractionary and expansionary monetary policies and the neutral rate.
Subject 6. Contractionary and expansionary monetary policies and the neutral rate.
An expansionary monetary policy decreases interest rate in order to increase the size of money supply. A contractionary monetary policy increases interest rate to reduce the size of money supply. The idea behind the concept of neutral rate of interest is that there might be a rate of interest that neither deliberately seeks to stimulate aggregate demand and growth, nor deliberately seeks to weaken growth from its current level. In other words, a neutral rate of interest would be that which encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP. The neutral rate is a useful method to measure the stance of monetary policy. It has two components:
- They cannot control the amount of money that households and corporations put in banks on deposit.
- They cannot control the willingness of banks to create money by expanding credit.
In a quantitative easing (QE), a central bank buys any financial assets to inject money into the economy. It is different from the traditional policy of buying or selling government bonds to keep market interest rates at a specified target value. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional money in order to increase their capital reserve.
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