Question

Name one potential mechanism for lowering interest rates from the perspective of the central bank. Explain how such a mechanism is implemented in reality. Use an appropriate short-run model/curve that we covered in class to explain how the central bank can uses this mechanism to combat (1) recession and/or (2) hyper-inflation.

Answer 1

The central bank has several monetary policy tools that can be used to influence money supply and hence the interest rate. One the the most commonly used tools of the central bank is open market operation that involves buying and selling of bonds in the open market.

To elaborate, when the economy is in recession, the central bank pursues expansionary monetary policy and the objective is to lower interest rates. In such a scenario, the central bank buys bonds from the open market. When banks and financial institutions sell these bonds, the banking system is infused with liquidity.

As liquidity in the banking system increases, the inter bank lending rate (federal fund rate in the United States) declines. This translates into lower interest rates for businesses and consumers. At lower interest rate, businesses are more willing to pursue leveraged investment spending and consumers are more willing to pursue leveraged consumption spending. As investment and consumption spending in the economy increases, GDP growth trends higher.

This can be explained with the help of an aggregate demand and aggregate supply model. The chart below gives the aggregate demand curve and the aggregate supply curve along with the long-run aggregate supply curve.

Initially, when the economy is in recession, the aggregate demand curve is represented by AD1. At this point, the actual output is lower that the potential output. When the central bank pursues expansionary monetary policy as explained above, the aggregate demand curve shifts to the right and the economy moves to potential output with the new aggregate demand curve represented at AD. Therefore, GDP increase along with an increase in price level.

When the economy is in an inflationary boom, the reverse policy is employed (contractionary monetary policy). This involves selling of bonds in the open market with banks and financial institutions buying the bonds. This tightens liquidity in the banking system as the central bank absorbs liquidity by selling bonds. The inter bank lending rate therefore rises and this translates into higher interest rates for consumers and businesses.

At higher rates, the consumers and businesses are less willing to pursue consumption and investment spending and economic activity declines on a relative basis (aggregate demand curve moves to the left). This also corresponds with lower price levels in the economy and inflation is curbed.