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LOS m. determine whether a monetary policy is expansionary or contractionary;
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:

Neutral rate = Trend growth + Inflation target

When the neutral rate is reached, the state of equilibrium is attained - implying that the economy is now well balanced and the price level is stable.

Certainly there can be no such thing as an exact measure of the neutral rate, and it will differ from country to country.

A demand shock is a sudden surprise event that increases or decreases demand. If an inflation is caused by an unexpected increase in aggregate demand, a contractionary monetary policy might be appropriate to cause the inflation to fall. However, if an inflation is caused by a supply shock such as a sudden increase in oil price, a contractionary monetary policy might make the situation worse.

Limitations of Monetary Policy

Central banks cannot control the money supply. This is because:

  • 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.
Practice Question 1

Mutual funds that allow deposits and withdrawals with minimal transactions fees:

A. serve as a medium of exchange and should be counted as part of the M-1 measure of the money supply
B. serve as a medium of exchange and should not be counted as part of the M-2 measure of the money supply
C. offer great liquidity so that owners of the mutual funds have quick and cheap access to additional purchasing power

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Practice Question 2

A tax cut reduces the amount of money that taxpayers owe the government and frees up money for personal spending. This can cause a:

A. Demand shock.
B. Supply shock.
C. Tax shock.

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Practice Question 3

If a central bank decides to increase interest rates, its monetary policy is said to be:

A. contractionary.
B. expansionary.
C. neutral.

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Practice Question 4

In a liquidity trap,

I. The short-term nominal interest rate is zero.
II. Monetary policy becomes completely ineffective.

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Practice Question 5

When the U.S. dollar is used as a medium of exchange in other countries:

I. the U.S. money supply is unchanged since it doesn't matter where U.S. currency is held.
II. the money supply in the U.S. is reduced.
III. the currency is still available for use as required reserves.

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Practice Question 6

Consider Hurricane Katrina's detrimental effect upon the oil and gasoline industry: oil rigs, refinement plants, and pipelines were either shut down or taken off line. This would likely to cause a(n):

A. Demand shock.
B. Supply shock.
C. Oil shock.

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Practice Question 7

True or false?

A determined central bank can always reflate the economy.

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Practice Question 8

If an inflation is caused by a demand shock, raising interest rates will likely:

A. bring down the inflation level.
B. push the inflation level further up.
C. increase the unemployment rate.

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Practice Question 9

Assume the neutral rate of interest is considered to be 4.5% at the moment. The current interest rate is at 6%. The central bank decides to lower the interest rate to be 5.5%. The central bank's current monetary policy is:

A. contractionary.
B. expansionary.
C. cannot determine.

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Practice Question 10

Which statement is FALSE regarding the neutral interest rate?

A. It is not affected by short-term imbalances in the economy.
B. It is a fixed number for a country but it varies across different countries.
C. Different economists may come up with different neutral rates of interest for any given economy at any time.

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