Monetary policy is the process by which a central bank influences the supply of money and credit in the economy. The goal of monetary policy is to achieve a set of macroeconomic objectives, such as price stability, economic growth, and employment.
There are two main theoretical underpinnings of monetary policy:
- The quantity theory of money: This theory states that the money supply is directly proportional to the price level. In other words, if the money supply increases, the price level will also increase.
- The interest rate channel: This theory states that monetary policy affects the economy through the interest rate. When the central bank raises interest rates, it makes it more expensive for businesses and consumers to borrow money. This reduces investment and spending, which slows down economic growth.
In addition to these two main theories, there are a number of other theories that have been used to explain the effects of monetary policy. These include the:
- Phillips curve: This curve shows the relationship between inflation and unemployment. It suggests that there is a trade-off between these two variables, such that if the central bank tries to reduce inflation, it will lead to higher unemployment.
- Rational expectations hypothesis: This hypothesis states that people form expectations about future economic conditions based on all available information. This means that they will not be fooled by changes in monetary policy that are not expected.
- Time inconsistency problem: This problem arises when the central bank has an incentive to make promises about future monetary policy that it cannot or will not keep. This can lead to inflation expectations that are higher than the central bank’s target.
MCQs on Monetary Policy Theoretical Underpinnings
- Which of the following is the main theoretical underpinning of monetary policy?
- A. The quantity theory of money
- B. The interest rate channel
- C. The Phillips curve
- D. The rational expectations hypothesis
The answer is (a). The quantity theory of money is the main theoretical underpinning of monetary policy.
- What is the relationship between the money supply and the price level?
- A. They are inversely proportional
- B. They are directly proportional
- C. They are not related
- D. There is no way to know
The answer is (b). The quantity theory of money states that the money supply is directly proportional to the price level.
- How does monetary policy affect the economy through the interest rate channel?
- A. By raising interest rates, the central bank makes it more expensive for businesses and consumers to borrow money. This reduces investment and spending, which slows down economic growth.
- B. By lowering interest rates, the central bank makes it more expensive for businesses and consumers to borrow money. This reduces investment and spending, which slows down economic growth.
- A. By raising interest rates, the central bank makes it cheaper for businesses and consumers to borrow money. This increases investment and spending, which speeds up economic growth.
- B. By lowering interest rates, the central bank makes it cheaper for businesses and consumers to borrow money. This increases investment and spending, which speeds up economic growth.
The answer is (a). When the central bank raises interest rates, it makes it more expensive for businesses and consumers to borrow money. This reduces investment and spending, which slows down economic growth.
- What is the Phillips curve?
- A. This curve shows the relationship between inflation and unemployment.
- B. This curve shows the relationship between the money supply and the price level.
- C. This curve shows the relationship between interest rates and the price level.
- D. This curve shows the relationship between interest rates and unemployment.
The answer is (a). The Phillips curve shows the relationship between inflation and unemployment.
- What is the rational expectations hypothesis?
- This hypothesis states that people form expectations about future economic conditions based on all available information.
- This hypothesis states that people form expectations about future economic conditions based on random guesses.
- This hypothesis states that people form expectations about future economic conditions based on the central bank’s promises.
- This hypothesis states that people form expectations about future economic conditions based on the central bank’s actions.
The answer is (a). The rational expectations hypothesis states that people form expectations about future economic conditions based on all available information.
Conclusion
The theoretical underpinnings of monetary policy are complex and there is no single theory that can fully explain how monetary policy works. However, the theories discussed here provide a basic understanding of the way that monetary policy can be used to influence the economy.