Question

Your essay must be written concisely and not exceed 700 words.

1. Monetary policy can be a useful tool for macroeconomic management. Using relevant diagram(s), show and discuss the possible impact of recent interest rate cuts on output, inflation and unemployment.

Answer 1

The Monetary Policy is used as an effective tool by the Central Bank of a country in order to manage the flow of money in the economy. Over the years, the world has now experienced a recession due to the Corona Virus Pandemic like none other. This recession is not due to any economic factor, but due to the fact that establishments remain shut, and consumer demand for goods and services is declining sharply. During this time, the flow of money in circulation is low, the aggregate or total demand as described is lower than market equilibrium and it creates a significant impact on business which in turn fires people and unemployment rises.

The Central Bank on its part has a lot of tools in order for it to be able to bring stability in the markets. Three main tools are as follows: -

1) Revising the Interest Rate or the Funds Rate which it charges from the banks for loans which they take. Revising the same directly impact the interest rates which commercial banks in turn charge from consumers and producers alike.

2) Then next is the minimum amount of cash reserve which commercial banks must hold at all times with the Central Bank. Revising this also impacts business and all related factors stated above.

3) The other alternative strategy is for the Central Bank to buy or sell bonds in the market to decrease or increase the flow of money in circulation.

As part of the current COVID crisis, the Central Banks have reduced the interest rates and other required margins for banks to work which gives them an edge in lending more money and helps in keeping interest rates lower. As interest rates decrease, the output and production capability increase and the aggregate demand goes up the employment rates also decrease as a result of the same.

The following graph will help you in understanding the same.

Here, in the above graph we see that the prices and interest rates fall down. As a result of the same, the equilibrium and demand shift from E1 to E2. The previous demand was Q1 and the employment and production and output were also reflecting accordingly. Post the Monetary policy of the Central Bank, all these shifted towards the left and demand and supply both increased. The resultant was a shift in unemployment levels as well as people would be employed if the interest rates are low and the market sees expansion.

Please feel free to ask your doubts in the comments section.