Answer to Question #284622 in Macroeconomics for gggg

Question

1.  Explain the effect of contractionary monetary and fiscal policy on income and interest rate based on the following cases. And support your explanation using graphs.

a.   There is fixed exchange rate regime and perfect capital mobility. 

Answer 1

According to macroeconomic theory, each economy has a "neutral rate of interest rate." A neutral rate of interest is one at which the economy expands near to its full potential while inflation remains steady (without exerting price pressure on the economy). The central bank is said to be following an expansionary monetary policy if it keeps the interest rate below the neutral rate of interest. When does an expansionary policy become effective: If there has been a recession and the economy's output is well below its potential output, and if inflation is very low and has been thus for a long time. People and businesses are encouraged to invest as the cost of financing falls, pushing the economy's growth rate higher. Price pressure arises as a result of the easy availability of money, pushing inflation upward. The central bank maintains the interest rate above the neutral rate of interest, which is the polar opposite of expansionary policy. It is commonly used when the economy has been growing over potential for a long time, increasing the likelihood that inflation may rise quickly.

 Monetary Policy and Interest Rates. The original equilibrium occurs at E₀. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S₀) to the new supply curve (S₁) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S₀) to the new supply (S₂), and raise the interest rate from 8% to 10%.

The Central Bank cannot undertake an autonomous monetary policy to promote domestic economic stability in a fixed exchange rate system with perfect capital mobility. The government, on the other hand, can adopt expansionary fiscal policy to boost national income and employment.