Question

7. Monetary policy

a. Explain how and why expansionary monetary policy affects the nation’s exchange rate.

b. Explain how and why contractionary monetary policy affects stock prices and the net worth of firms. According to Tobin’s q, what is the implication for the effect of contractionary policy on desired investment spending by firms? Explain.

c. According to the credit channel theory of monetary policy transmission, how does expansionary monetary policy affect adverse selection problems in credit markets? Explain.

Answer 1

7) Monetary policy is the process by which the monetary authority of a country, typically the central bank or currency board, controls either the cost of very short-term borrowing or the monetary base, often targeting an inflation rate or interest rate to ensure price stabilityand general trust in the currency

a) Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases aggregate demand. It boosts growth as measured by gross domestic product. It usually lowers the value of thecurrency, thereby decreasing the exchange rate.

b) Contractionary monetary policy impacts stock prices but this is temporary and largely a knee-jerk reaction to the degree of change in interest rate vis-à-vis the expectations.

So the stock prices won’t be impacted if the market is expecting the RBI to raise interest rate by 0.5%, and the RBI does exactly the same.

c) The credit channel of monetary policy transmission is an indirect amplification mechanism that works in tandem with the interest ratechannel. The credit channel affects the economy by altering the amount ofcredit firms and/or households have access to in equilibrium.