Question

Describe using words, graphs and all appropriate mathematics the various factors that would make monetary policy ineffective in changing output in the short run. Be as detailed as possible.

Answer 1

Monetary policy is effective as long as it is able to push down interest rate and increase investment activities in economy. Monetary policy becomes ineffective when it fails to affect interest rate. Situation when monetary policy is quite ineffective in reducing interest rate is called liquidity trap.

Bond price and interest rate are inversely related. Decrease in interest rate pushes up bond price. Thus, investor expect that now in future interest rate will rise and bond price will fall, So they are reluctant to make investment. They keep the cash in liquid form. So, Liquidity in economy is get trapped in hand. Thus, monetary policy is not able affect interest rate.

Following is diagram:

In above diagram, at lower level of interest rate, investors tend to hoard lot of liquid money, so when money supply is increased from Ms 1 to Ms2 and Ms3, there is not effect on interest rate or interest rate does not fall further.

Thus, horizontal form of demand curve make our monetary policy ineffective.