IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy
A central bank cuts its policy rate, but banks and firms are highly pessimistic about the economy, banks are cautious about credit risk, and interest rates are already very low. Which outcome is the most likely explanation of a weak response in lending and spending?
This is a liquidity-trap type situation. With very low rates, weak confidence and cautious banks, demand for credit becomes insensitive to further cuts, so extra liquidity is held rather than lent or spent, and the transmission mechanism fails to lift aggregate demand.
- AMonetary policy is then said to face a liquidity-trap type problem, where demand for credit is insensitive to further rate cutsCorrect
- BThe quantity theory implies prices must fall immediately
- CThe central bank's rate cut automatically raises the exchange rate and exports
- DFiscal policy is rendered ineffective by the rate cut
- Velocity of circulation rises mechanically to offset the cut
Explanation
When rates are very low and confidence is weak, investment demand is interest-inelastic and banks ration credit, so extra liquidity is hoarded rather than spent. This is the liquidity-trap or 'pushing on a string' problem. The other options are not implied: a cut tends to weaken, not strengthen, the currency, and fiscal policy is not made ineffective.
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