Unit 13: Monetary Policy Transmission
How one interest rate decision travels from the money market through investment to output, and why that trip can take a year and a half.
5 topics · 17 questions
Each topic is a path, not a menu: work down it in order and every question builds on the one above. Click any of them to watch the answer draw itself.
The Money Market and the Nominal Interest Rate
- How it worksHow do money demand and a fixed money supply together set the nominal interest rate?
- Common mistakeWhy isn't the money supply curve upward sloping the way an ordinary supply curve is?
- Going furtherWhat happens in the money market when real GDP grows and pushes up the demand for money at every interest rate?
Your turn1 of 2
Money demand is L = 3696 minus 95 times i, where i is the nominal interest rate, and the money supply is fixed at 2746 billion dollars. Find the equilibrium nominal interest rate.Monetary Policy Transmission to Investment and Aggregate Demand
- How it worksWalk me through expansionary monetary policy traveling from the money market to business investment to aggregate demand.
- Worked exampleFind the direction the interest rate, investment, aggregate demand, and output move after the central bank sells bonds.
- Common mistakeWhy doesn't cheaper borrowing raise output when an economy is already sitting at full employment?
- Going furtherWhat happens when contractionary monetary policy is used specifically to close an inflationary gap?
Your turn1 of 2
Investment spending falls by 24 billion dollars for every 1 percentage point rise in the interest rate. If the central bank raises rates by 1.47 percentage points, and the resulting fall in investment then multiplies through the economy by a spending multiplier of 4, what is the total change in real GDP?The Zero Lower Bound and Liquidity Traps
- How it worksHow does a liquidity trap leave monetary policy unable to push the interest rate down any lower to boost spending?
- Common mistakeWhy doesn't hitting the zero lower bound mean a central bank has completely run out of tools?
- Going furtherWhat happens to a stalled aggregate demand curve once a central bank turns to large-scale asset purchases instead of rate cuts?
Your turn1 of 2
A central bank has already cut its policy interest rate all the way down to zero and cannot cut it further. A commentator declares it has completely run out of tools. Does the central bank still have tools available at the zero lower bound?Comparing Monetary and Fiscal Policy
- How it worksWalk me through expansionary fiscal policy and contractionary monetary policy pulling the interest rate in opposite directions.
- Common mistakeWhy doesn't a government and a central bank pulling in the same direction simply double the total effect?
- Going furtherWhat happens to output and interest rates when both fiscal and monetary policy expand together at the same time?
- Ties togetherHow do the money market, loanable funds, and AD-AS graphs all move together inside one coherent policy story?
Your turn1 of 2
Expansionary fiscal policy raises the interest rate by 0.927 percentage points, while contractionary monetary policy raises it by another 0.884 percentage points at the same time. What is the total rise in the interest rate from both policies combined?Lags and Limits of Monetary Policy
- How it worksHow do recognition lags and adjustment lags stretch a single policy action out across most of a business cycle?
- Common mistakeWhy isn't a lower policy rate always enough on its own to get nervous firms borrowing again?
- Going furtherWhat happens to the length of these lags once a central bank starts announcing its future rate plans well in advance?
Your turn1 of 2
A central bank cuts its policy rate, expecting nervous businesses to start borrowing and investing again right away. Months later, businesses are still reluctant to borrow. Can firms stay reluctant to borrow even after the rate has come down?