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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

A central bank wants to reduce inflationary pressure by using its main short-term policy instrument. Which action is most consistent with this aim?

Raising the policy repo rate is the correct action. Higher policy rates push up market borrowing costs, reduce consumption and investment, and so ease demand-pull inflation. Cutting rates, buying securities or lowering reserve ratios all increase liquidity and credit, which would tend to raise inflation instead.

  1. ARaising the policy repo rate so that borrowing costs across the economy tend to riseCorrect
  2. BLowering the policy repo rate to encourage firms to borrow and invest more
  3. CBuying government securities in the open market to inject liquidity
  4. DReducing the cash reserve ratio required of commercial banks
  5. Announcing a fixed exchange rate target below the current market rate

Explanation

Contractionary monetary policy raises the policy rate, which feeds into bank lending and deposit rates, dampening borrowing, spending and demand-pull inflation. The other options (cutting rates, buying securities, lowering reserve requirements) all expand liquidity and would add to inflationary pressure.

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