Question

Why does expansionary monetary policy causes interest rates to drop?

Short answer

Expansionary monetary policy causes interest rates to drop as it increases the money supply in the economy, leading to a higher supply of money compared to its demand. This prompts banks to lower interest rates to make borrowing more attractive and competitive, ultimately encouraging borrowing, spending, and investment by consumers and businesses, thereby stimulating economic growth and helping to combat recession.

Step-by-step solution

Understanding Expansionary Monetary Policy

Expansionary monetary policy is a tool used by central banks to stimulate economic growth and combat recession. It involves increasing the money supply in an economy, typically done by lowering reserve requirements, buying government bonds, or lowering the discount rate. As a result, banks have more money available to lend, and businesses and individuals find it easier to access credit at lower rates.

Understanding the Money Supply and Demand

The money supply refers to the total amount of money available in an economy. The demand for money is influenced by various factors like income, prices, and interest rates. When the central bank implements expansionary monetary policy, the money supply increases, leading to a rise in the amount of money available for borrowing.

Understanding the Impact of Increased Money Supply on Interest Rates

When the money supply increases, the equilibrium between the demand and supply for money is disrupted. The supply of money becomes higher compared to its demand, putting downward pressure on the interest rates. This happens because banks have a surplus of funds that they want to lend out at competitive rates, leading to lower interest rates.

Explaining Lower Interest Rates Effects on Borrowing and Spending

Lower interest rates make borrowing less expensive for individuals and businesses. As a result, both consumers and businesses are more inclined to take out loans and spend money, helping spur economic growth. In turn, this leads to increased investment, higher levels of consumption, and a rise in aggregate demand, all of which help to combat unemployment and improve the overall economy.

Conclusion

Expansionary monetary policy causes interest rates to drop because it increases the money supply, leading to a higher supply of money compared to demand. This causes banks to lower interest rates in order to make borrowing more attractive and competitive. Lower interest rates encourage borrowing and spending by businesses and consumers, which in turn stimulates economic growth and helps to combat recession.