Response
Response
5. Explain the effectiveness of monetary policy.
Monetary policy is an item that is used by the state or author in an attempt to control instances of inflation and ensure that there is price stability. The central bank has the mandate to monitor the growth and the size of the money supplied. Various strategies are used to control and maintain the monetary policy. For example, selling or buying the government bonds, adjusting interest rates and managing the bank reserves (Galí & Gertler, 2009).
Monetary policy is effective. This is based on the expansionary policy. If an increase in the supply of money is witnessed, then the interest rate will fall. Further, owing to the fall in interest rate, the rate of spending rises, for example, in investment expenditure. On the other hand, some mechanisms may not make the model function as expected like the essence of the liquidity trap. According to Keyes, the occurrence of the liquidity trap may prevent the downfall of the interest rate owing to the increase in the supply of money (Nishiyama, 2012). The scenario engages the public to withhold the money they possess hence affecting the interest rate in the market.
Y
LM2
R1 E
Interest rate R2
IS
0 Y1 Y2 X
The above diagram is an example concerning an increase in income and its effect on the interest rate. The fall of the interest rate leads to the shift of the LM curve from LM1 to LM2. Additionally, this will result in increase of the real national income from Y1 to Y2. In the scenario above, it can be observed that the LM curve is not effective since it is flat (Papademos, n.d.). In the US, it was the lack of effectiveness of the monetary policy was due to bank reluctance in making it possible to lent money. The banks opted to lend to the real estates in the state of lending to the private investors.
References
Galí, J., & Gertler, M. (2009). International dimensions of monetary policy. Chicago: University of Chicago Press.
Nishiyama, Y. (2012). Monetary policy: Roles, forecasting and effects. Hauppauge, NY: Nova Science Publishers.
Papademos, L. (n.d.). The Effects of Globalization on Inflation, Liquidity, and Monetary Policy. International Dimensions of Monetary Policy, 593-608. doi:10.7208/chicago/9780226278872.003.0012
