Question

7. i) Explain briefly the interest rate channel and the credit channel. ii) When monetary policy fails to be an effective economic policy tool? iii) What is a credit crunch?

Answer 1

i)

Intereset Rate Channel: shows how a policy-induced change in the nominal interest rate affects ultimately the price level and then output and employment levels

Below is the sequence of its occurrence:

Change in the Short Term Nominal Interest Rate ---> Affects long term nominal interest rate ---> Affects long term real interest rate ---> Impacts spending on goods and services ---> changes the Real GDP ---> Inflation through output gap emergence ---> Apply Taylor Rule ---> Interest Rate targeting using inflation gap and output gap.

So, the main idea of the channel is to anchor the real equilibrium fed funds rate to the target fed funds rate.

Credit Channel:

It stands on the idea of Changing the amount of credit through interest rate so that such changes can impact the real macro variable such output and employment

In this channel, Central Bank first reduces the interest rate. This requires more reserves to be kept by the banks. They will be able to lend more loans to the public and hence, the aggregate demand in the economy will rise through increasing purchasing power of the public.

ii.

Liquidity Trap is a situation where the monetary policy fails to work. An expansionary monetary policy leads to increase in the bank's reserves but does not lead to bank's lending. So, the Credit Channel stops working and the policy fails. All injected money is hold by the public in their hands.

iii.

Credit Crunch is a sharp reduction in the availability of credit from banks and other lenders. A significant decline in the lending activities occurs from the bank's end. And the economy faces a liquidity crisis.