Question

4. Explain the following problems associated with monetary policy
   1. Why are there limits to the extent we can use monetary policy to stimulate GDP?
   2. Explain the concept of a liquidity trap.
   3. What is the long run effect of a monetary expansion on the real economy?

Answer 1

a. As interest rates are low and asset prices increase, higher net worth of lenders resulting from higher collateral prices eases borrowing constraints and allows excess accumulation of credits. Furthermore, accommodating monetary policy will contribute to increased risk-taking by financial institutions and investors: low interest rates may incentivize investors with nominal return goals to achieve yield. Low rates could strain banks 'profit margins and incentivize them to retain riskier assets, or higher asset prices could cause them to underestimate risk given their risk management models and corporate structures of limited liability.

Just a quick look at the provisions of the Dodd-Frank Act reveals that Congress gave the FSOC a very broad collection of tools specifically so that it could get through all the cracks by adjusting the incentives of the financial market participants and the financial market structure as required to avoid major financial instability. If these tools are used efficiently and judiciously, monetary policy will concentrate more systematically on the question of moving the real economy towards full employment and higher wages.

b. An economic condition where people hoard financial capital instead of saving or spending it is a liquidity trap. As a result, the central bank of the nation can not implement expansionary monetary policy to fuel economic development. This also happens when the interest rates in the short term are zero. For monetary policy central banks are responsible for controlling liquidity. A main strategy for promoting borrowing is to reduce interest rates. That makes loans cheap and encourages businesses and families to borrow to invest and spend.

c. Economic development is driven by such factors as technological transition, population growth, and accumulation of human resources.
The effect of monetary policy on real economic activity is minimal and temporary, while poorly applied monetary policy can persistently impede economic growth.
Monetary policy is unique in its potential to influence the long-run price level through the money development process. That remains valid even in an environment with reserve interest and high balance of bank reserve accounts.