4) Consider an economy where interest rates are already extremely low because th

Question

4) Consider an economy where interest rates are already extremely low because the supply of funds is very high. Nevertheless, the economy remains weak (that is, output is low). Explain why monetary policy might be very ineffective in raising output levels 4) Consider an economy where interest rates are already extremely low because the supply of funds is very high. Nevertheless, the economy remains weak (that is, output is low). Explain why monetary policy might be very ineffective in raising output levels

Explanation / Answer

When federal reserve lower down its interest rates, commercial banks will start giving more loans in the market, this money will flow to the population in the form of income, wages etc, thus it increases the purchasing power of the people, now people will create more aggregate demand and to attain this equilibrium the supply side will rise, this monitory policy of federal reserve is called expansionary monitory policy, now if the public decide to hold there money and prevent the rate of interest from falling further, this is called as liquidity trap, basically public is prepared to hold whatever the money is supplied at a given rate, since they will not spend the output will remain unchanged and economy remains weak despite elastic nature of money supply, thus making monitory policies ineffective.

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