Question

This question has 3 parts each worth 10 point. This question is related to the monetary policy.

i) (10 points) What is the difference between a stimulative monetary policy and a restrictive monetary policy? In what circumstances should each of the policies be used?

ii) (10 points). Discuss the effect of an expansive (stimulative) monetary on the cost of debt, on the cost of equity, and total cost of capital of a firm?

iii) (10 points). During the initial recovering of the business cycle, which (stimulative or restrictive) monetary policy should be used? Why?

Answer 1

Ans i) Stimulative monetary policy: When central bank reduce its interest rate and push more money in the economy. This policy is mainly used by the central back when growth rate of the economy is less.

Restrictive monetary policy: When the central bank increase interest rate and pull out money from the economy. This stance is mainly taken by the central bank when the inflation is very high.

Ans ii) Since the interest rate reduced by the central bank during stimulative monetary policy, equity value will be increased which lead to decrease in cost of equity, at the same time cost of debt will be reduced as well as both will be reduced total cost of capital of a firm will be decreased.

Ans iii) During initial recovering of the business cycle stimulative monetary policy should be used because it accelerate the economic activity and lead to higher growth rate. It helps in simulating economic activities in the world.