Question

Then the double-whammy: After causing a recession, deflation can make it difficult for monetary policy to work. Say that the central bank uses expansionary monetary policy to reduce the nominal interest rate all the way to zero—but the economy has 5% deflation. As a result, the real interest rate is 5%, and because a central bank cannot make the nominal interest rate negative, expansionary policy cannot reduce the real interest rate further. (True/False)

Answer 1

The statement is true as deflation (negative inflation) increases the real interest rate when the nominal rate is at zero, thereby constraining the central bank's ability to use monetary policy to stimulate the economy.

Step-by-step explanation:

The statement addresses a situation where deflation complicates the effectiveness of expansionary monetary policy. When there's a 5% deflation, even if the nominal interest rate is reduced to zero by the central bank, the real interest rate would still be 5%. This is because the real interest rate is calculated as the nominal interest rate minus the inflation rate (which is negative in the case of deflation, essentially adding to the nominal rate). Therefore, since central banks conventionally cannot set negative nominal interest rates, they cannot lower the real interest rate further in such a scenario, thus limiting the power of monetary policy to stimulate the economy.

In practice, some central banks have experimented with negative interest rates, though this is controversial and not widely accepted as standard policy.