Question

Monetary policy can be a useful tool for macroeconomic management. Using relevant diagram(s), show and discuss the possible impact of recent interest rate cuts on output, inflation and unemployment

Answer 1

A cut in interest rates will cause the following effects:

• Output: output will increase because an interest rate cut makes credit cheaper. Firms will now borrow more money at cheaper interest, and will invest those funds in producing more.
• Inflation: an interest cut is produced by an increase in the money supply. When the money supply increases, inflation goes up as well.
• Unemployment: unemployment will go down. Because there is more money in the economy, there is also cheaper credit, and as explained above, firms will make use of these cheap credits to invest more and produce more. To do so, they will need to hire more workers.