Question

1.Explain the pathways of monetary policy, and some of the potential pitfalls for monetary policy.

Answer 1

Answer:

• There are several types of monetary policy, but the main functions of a monetary policy involve the central bank changing the money supply in the economy. The central bank can adopt an expansionary monetary policy or a contractionary monetary policy.
• An expansionary monetary policy, let's say in the form of open market operations, is when the central bank buys bonds from commercial banks and supplies money in return. This increases the money supply in the market, driving down interest rates in the market. This has the effect of people now having more access to liquidity and can easily finance their loans.
• A contractionary monetary policy, in the form of open market operations, is when the central bank decides to sell bonds and securities to the commercial banks and receives money in return. Therefore this contracts the money supply in the market, driving the interest rates up. People now have access to less liquidity.
• One of the ways to fight inflation (high prices) is by implementing a contractionary monetary policy. Less money supply & high-interest rates mean less spending and thus the prices of goods will also drop.
• However, there is a lot of unpredictability involved in monetary policy. For instance, the monetary policy takes time to implement and be effective. Therefore, by the time it starts to work, the economy may be in a different stage of the business cycle where the monetary policy may not be applicable. The central bank can increase money supply however the overall power to allow access to liquidity is with the commercial banks. Commercials banks have the authority to decide whether they will lend to people or not.