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2281 · 4.4

Monetary policy — practice questions

Practice and worked examples for 2281 Monetary policy. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

A central bank cuts its policy rate from 5% to 3% during a recession (Y < Yf, unemployment 9%).

(a) Trace the transmission mechanism to AD. (b) Show the effect on P and Y using AD–AS. (c) Give two reasons why the cut might be ineffective.

Show solution outline

(a) Transmission mechanism Rate 5% → 3% → mortgage and loan costs fall → C rises; firms' borrowing costs fall → I rises; lower r attracts less foreign capital → currency depreciates → (X−M) rises → AD shifts right.

(b) AD–AS effect Draw AD₁ → AD₂ (rightward shift). New equilibrium: Y rises (toward Yf), P rises slightly. Recessionary gap narrows; unemployment falls.

(c) Ineffectiveness

  1. Liquidity trap / confidence: firms won't invest despite low r if demand expectations are pessimistic (I inelastic).
  2. Time lags: 18–24 months before full impact — recession may deepen before policy bites.

Worked example 2

Inflation is 8%, unemployment 4% (below NAIRU), and Y > Yf.

(a) Recommend monetary policy action. (b) Calculate the approximate real interest rate if nominal rate is 6% and inflation is 8%. (c) Explain one conflict with the growth objective.

Show solution outline

(a) Policy action Contractionary monetary policy — raise interest rates to reduce C and I, shift AD left, and control demand-pull inflation.

(b) Real interest rate Real r ≈ Nominal r − Inflation = 6% − 8% = −2%

Even with 6% nominal rate, real borrowing cost is negative — may still be stimulating AD; central bank may need a larger rate rise.

(c) Conflict with growth Higher rates reduce I and C → AD falls → growth slows and unemployment may rise — trade-off between price stability and employment/growth.

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