Question

Explain how the Central Bank could use three instruments of monetary policy to undertake expansionary monetary policy. Are there any possible negative consequences associated with expansionary monetary policy?

Answer 1

A central bank can use open market operations, reserve requirements, and discount rates to undertake expansionary monetary policy. However, there can be negative consequences associated with such policy, such as inflation, asset price bubbles, and impact on exchange rates.

Step-by-step explanation:

A central bank can use three instruments to undertake expansionary monetary policy:

1. Open market operations: The central bank can buy government bonds from banks, injecting money into the economy and increasing the money supply.
2. Reserve requirements: The central bank can lower the amount of reserves banks are legally required to hold, allowing them to lend out more money and increase the quantity of loans.
3. Discount rates: The central bank can lower the interest rate it charges on loans to commercial banks, making borrowing cheaper and encouraging banks to offer more loans.

However, there can be potential negative consequences associated with expansionary monetary policy. These include:

• Inflation: Increasing the money supply may lead to inflation if the increase in aggregate demand outpaces the increase in output.
• Asset price bubbles: Low interest rates may encourage excessive risk-taking and lead to speculative asset bubbles, such as a housing bubble.
• Impact on exchange rates: Expansionary monetary policy may weaken the country's currency, which can have both positive and negative effects on trade and the domestic economy.