Question

Why does expansionary monetary policy causes interest rates to drop?

Short answer

Expansionary monetary policy causes interest rates to drop primarily due to the increase in the money supply. Tools such as open market operations, adjusting reserve requirements, and setting discount rates are used by central banks to increase the money supply. As the money supply increases, the demand for money is more easily met, leading to lower interest rates. This encourages borrowing, spending, and investment, stimulating economic growth.

Step-by-step solution

1. Understand expansionary monetary policy

Expansionary monetary policy is a type of monetary policy used by central banks to stimulate economic growth. They accomplish this by increasing the money supply, which in turn lowers interest rates. Lower interest rates encourage increased borrowing, spending, and investment, which ultimately leads to economic growth.

2. Identify the tools of expansionary monetary policy

Central banks have several tools to influence the money supply and interest rates. These include open market operations, adjusting reserve requirements, and setting discount rates. In open market operations, the central bank buys government securities, which injects new money into the economy. Reserve requirements influence how much money banks can lend out, and the discount rate is the rate at which banks can borrow money from the central bank.

3. Analyze the interaction between money supply, demand for money, and interest rates

Interest rates are determined by the supply of and demand for money in the economy. When the money supply increases, there is more money available for borrowing, investing, and spending. As a result, the demand for money is met more easily, which leads to a decrease in interest rates. Conversely, if the money supply is constrained and the demand for money is high, borrowers are willing to pay higher interest rates to access limited funds.

4. Explore the effect of open market operations on interest rates

In expansionary monetary policy, the central bank purchases government securities from financial institutions in an attempt to increase the money supply. This leads to an increase in the amount of funds available in the banking system. As the supply of money increases, the banks become more willing to lend money at lower interest rates, which leads to a decrease in the overall interest rates.

5. Discuss the impact of reserve requirements and discount rates on interest rates

Central banks adjust reserve requirements to control the amount of money banks can lend out. Lowering reserve requirements allows banks to lend out more of their deposits, which increases the money supply and helps lower interest rates. Similarly, the central bank may lower the discount rate, making it less expensive for banks to borrow additional funds from the central bank. By doing this, banks have more funds to lend and interest rates are pushed down further. By understanding how expansionary monetary policy works and its direct impact on money supply, demand for money, and interest rates, we can conclude that the primary reason expansionary monetary policy causes interest rates to drop is due to the increase in the money supply. This increase leads to a more easily met demand for money, resulting in lower interest rates and ultimately stimulating economic growth.