Question

Since the end of the Great Recession, interest rates have been at historic lows—in some cases, close to zero. How is expansionary monetary policy, or more specifically a open market purchase, supposed to work? How do near-zero interest rates limit the ability of expansionary monetary policy to work?

Answer 1

Case Specifics

To increase spending in the economy, interest rates are kept low so that people have lesser incentive in saving money and spend freely. This creates higher liquidity in the market, and the forces of supply and demand remain strong.

During an economic crisis, the Federal Reserve usually expands business by increasing the fluidity in the market place. This is done by reducing the reserve requirements for banks that then causes banks to have higher amounts of money with them which can be given away as loans or techniques such as reducing the interest rates for banks, which in turn can lead to lower public interest rates, again giving them support.

Open Market Purchases on the other hand, are taken when the Federal Reserve directly purchases bonds from the market. The resultant purchase results in higher flow of money in the economy, as the money is transferred directly from the Federal Reserves to those who sell their bonds. This increases the supply of money in the economy, thus having a fruitful impact on demand and supply.

Demerits of Zero Interest Rates: -

When interest rates are at 0 levels throughout in a country, the economy cannot create money by reducing interest rates any further. Interest rate reductions are done, primarily to enable people to have more money and demand more goods and services during a recession. When interest rates are already at 0 levels, the Federal Reserve cannot use it as a policy tool as there is no scope for reducing interest rates any further.

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