Contractionary and Expansionary Monetary Policies and the Neutral Rate

Imagine living in an economy that is experiencing rapid economic growth but is also undergoing worrisome levels of inflation. In this case, monetary policy might be used to contain price level growth. More specifically, a central bank may seek to increase interest rates in order to slow economic activity and limit inflation. If you were considering undertaking a big investment—perhaps building a strip mall in your neighborhood—how would higher interest rates influence your decision?

Incorrect. Assuming you had to borrow some of the money needed for construction, higher interest rates might discourage this project.

Correct! With lower interest rates, borrowing costs would fall and that may make this investment more lucrative. When a contractionary monetary policy like this is used, interest rates rise, investment is curtailed, domestic demand falls, and upward pressure on prices subsides.

Incorrect. It is not clear whether that is actually a policy or not, but it does not sound enjoyable.

Contractionary monetary policy involves increasing interest rates to contain inflation. Conversely, expansionary monetary policy involves lowering interest rates to stimulate economic activity. Given these two endpoints, it might make sense that there is some interest rate that strikes a balance between these alternatives. Economists call that rate the __neutral rate of interest__. Which of the following do you think most accurately describes what happens to investment based on the neutral rate of interest?

Correct! With rates that are lower than the neutral rate, more investment is undertaken and consumers borrow more. Keep in mind that an increase in economic activity can also push the price level higher as domestic demand revs up.

Incorrect. Relatively low interest rates, below the neutral rate, encourage investment. In fact, these low rates are often used (via monetary policy) to combat recessions!

Incorrect. Rapidly accelerating economic growth is more likely when interest rates are relatively low, well below the neutral rate of interest.

If an economy typically grows by 3% in real terms (called the long-term real term trend growth rate) and that economy’s central bank has selected 4% as its inflation target, then the neutral rate of interest is the sum of these two figures, or 7%. Interest rates above 7% are considered contractionary while interest rates below 7% are considered expansionary.

In some cases, either long-term real trend growth rates or inflation targets can change. Imagine that global economic conditions, such as a financial crisis, have reduced long-term real trend growth rates in a particular country to 2%. At the same time, the central bank has lowered the inflation target to 3%. Given these changes, what is the neutral rate of interest in this economy?

Incorrect. It appears that the long-term real trend growth rate was subtracted from the inflation rate to arrive at this figure. Recall that the neutral rate of interest is the sum of the long-term trend growth rate and the inflation rate.

Correct! The sum of long-term real trend growth (2%) and the target inflation rate (3%) is in this case equal to 5%. At that rate of interest, neither inflationary pressure nor accelerating economic conditions would be expected.

Incorrect. It looks like the long-term trend growth rate and the inflation target have been multiplied here. Note that the neutral rate of interest is the sum of the inflation target and the long-term real growth rate. Put another way, it is the potential nominal economic growth rate.

In summary: [[summary]]

With higher interest rates, I'd be more willing to undertake this investment

With higher interest rates, I'd be less willing to undertake this investment

With higher interest rates, I'd face punitive and prohibitive taxation policy

When interest rates are below the neutral rate of interest, more investments occur and economic activity accelerates

When interest rates are below the neutral rate of interest, investment declines and economic activity decelerates

When interest rates are above the neutral rate of interest, economic activity is probably accelerating rapidly

1%

5%

6%

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