Paradise is suffering from a severe recession brought on by a massive financial
ID: 1102798 • Letter: P
Question
Paradise is suffering from a severe recession brought on by a massive financial panic. The Central Bank of Paradise has decided to use monetary policy to try to increase real GDP and reduce unemployment Below is a list of steps the economy takes from the decision to increase the money supply to the hoped-foir reduction in unemployment. Place the steps in the correct order. The liquidity trap makes monetary policy ineffective Unemployment increases Banks have excess reserves The central bank buys Paradisian Treasury securities Firms borrow more funds for capital investment projects. Firms hire more workers Banks lower interest rates to attract more borrowers Unemployment decreases in reducing unemployment Place in the bin all of the statements below that a liquidity trap could prevent. Interest rates decrease Firms borrow more funds Banks try to make more loans The central bank buys Treasury securities Banks hold reserves greater than the required minimumExplanation / Answer
1.
Monetary policy: This is the policy of government regarding the money supply in the market. Objective of this policy is to regulate the supply of money in the market by controlling interest rates, purchasing or selling securities, etc.
Steps are as below:
Unemployment increases: It happens because of the recession.
Banks have excess reserve: This is also the effect of recession.
Central bank buys securities: This is a monetary policy to boost up the economy.
Banks lower interest rates: It helps to attract more investors and firms.
Firms borrow for investment project: This is the effect of decreasing interest rates.
Firms hire workers: This is required for the successful conduct of those projects.
Unemployment decreases: This is the ultimate goal which is reached.
2.
If an increase in supply of money in an economy can’t decrease the rate of interest, then this is the liquidity trap. In this trap country’s monetary policy becomes ineffective.
Liquidity trap could be prevented if:
Decrease in interest rate: It can increase the supply of money.
Firms borrow: This is the effect of decreasing interest rates.
Banks try to make more loans: More loans means more supply of money. This can maintain the decreasing interest rates.
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