How does an expansionary monetary policy affect the rate of interest and level of income ?
- (a)Raises the level of income but lowers the rate of interest
- (b)Raises the rate of interest but lowers the level of income
- (c)Raises both, the rate of interest and the level of income
- (d)Lowers both, the rate of interest and the level of income
Answer
Why
Correct — A, (a) Raises the level of income but lowers the rate of interest.
An expansionary monetary policy is one in which the central bank increases the supply of money — by cutting the policy rate, by lowering the cash reserve ratio or the statutory liquidity ratio, or by buying securities in the open market. Trace what that does in the standard IS-LM framework, which is the framework the question is written from.
The money market clears where the demand for money equals its supply. Demand for money falls as the rate of interest rises, because interest is what a holder of money gives up by not holding a bond. So if the supply of money is increased while income is momentarily unchanged, there is more money in existence than people wish to hold at the ruling rate. They try to move out of money and into bonds; bond prices are bid up; and the rate of interest, which moves inversely to bond prices, FALLS. In IS-LM language, the LM curve shifts to the right.
The lower rate of interest then works on the real side. Investment spending is inversely related to the rate of interest, because a project is worth undertaking only if its expected return exceeds the cost of the funds. A lower rate makes projects at the margin worth doing, investment rises, and through the multiplier the rise in investment raises output and hence the level of income. So income RISES.
The two movements are in opposite directions, and that is the whole content of the question: an expansionary monetary policy lowers the rate of interest and raises the level of income. This opposite-direction result is what distinguishes monetary from fiscal expansion. An expansionary FISCAL policy — higher government spending or lower taxes — also raises income, but it raises the rate of interest, because higher income raises the transactions demand for money against an unchanged money supply. A candidate who has the two policies clearly separated answers this immediately; a candidate who remembers only 'expansionary means more of everything' has nothing to choose between (a) and (c).
Why the others are wrong
- (b)Raises the rate of interest but lowers the level of income — This is the exact reverse of the answer and describes a CONTRACTIONARY monetary policy — a rise in the policy rate, a rise in reserve requirements, or open-market sales. There the supply of money is reduced, holders find themselves short of money at the ruling rate, they sell bonds, bond prices fall and the rate of interest rises; the higher rate then cuts investment and, through the multiplier, lowers income. Every step is correct economics and every step is attached to the wrong policy. The option is on the page for the candidate who reads the direction of the policy carelessly.
- (c)Raises both, the rate of interest and the level of income — This is the outcome of an expansionary FISCAL policy, not a monetary one. Higher government spending or lower taxes shifts the IS curve to the right: income rises directly, the higher income raises the transactions demand for money, and with the money supply unchanged the rate of interest is bid up — which is the mechanism of crowding out. Because the phrase 'expansionary policy' is common to both, this is the most attractive of the three wrong options, and separating the two policies by the DIRECTION they move the rate of interest is the cleanest way to keep them apart. The comma after 'both' is the Commission's own punctuation.
- (d)Lowers both, the rate of interest and the level of income — This combination does not follow from an expansionary monetary policy under the standard assumptions. It takes the correct effect on the rate of interest and then reverses the effect that follows from it: a lower rate of interest raises investment, and higher investment raises income through the multiplier, so income cannot fall along the same chain. The pairing would need a separate contractionary force acting on the real side at the same time, and nothing in the stem supplies one. Like option (c), it prints the comma after 'both' as the booklet sets it.
Concept
The item is a compact test of the IS-LM transmission mechanism, which is the standard framework for comparing monetary and fiscal policy.
THE LM SIDE. The demand for money has a transactions component that rises with income and a speculative component that falls as the rate of interest rises. Equilibrium in the money market therefore ties income and the rate of interest together in an upward-sloping LM curve. An increase in the money supply shifts LM to the right: at any given income the market now clears at a lower rate of interest.
THE IS SIDE. Goods-market equilibrium requires planned spending to equal output. Investment falls as the rate of interest rises, so the IS curve slopes downward. It shifts when autonomous spending changes — government expenditure, taxes, exports, autonomous consumption.
THE TWO EXPANSIONS COMPARED. Monetary expansion shifts LM right and moves the economy DOWN along IS: income up, rate of interest DOWN. Fiscal expansion shifts IS right and moves the economy UP along LM: income up, rate of interest UP.
That single contrast answers a large family of questions, because the effect on income is the same in both cases and the effect on the rate of interest is opposite. It is also the origin of the crowding-out argument, which is about fiscal expansion pushing the rate of interest up and squeezing private investment.
Two limiting cases are worth carrying. In a liquidity trap the LM curve is horizontal, so a monetary expansion cannot push the rate of interest lower and has no effect on income. Where investment is wholly insensitive to the rate of interest, the fall in the rate produces no rise in investment and again no rise in income. Both are the standard Keynesian qualifications to the answer, not exceptions to the reasoning.
This is a textbook macroeconomics item asked in the plainest possible form: no numbers, no policy instrument named, and four options that exhaust the combinations of up and down for two variables. When an option set is constructed by exhausting combinations like this, the examiner is testing whether the candidate can produce the direction of each effect independently, because guessing between four exhaustive combinations gains nothing.
The EPFO's interest in monetary policy is not academic. The organisation manages an enormous accumulated fund whose returns depend on the interest-rate environment, and the rate declared on provident fund balances is debated every year against what the fund can actually earn. Falling interest rates, which are the object of an expansionary policy, are good for a borrower and difficult for a long-horizon fund that must service a declared rate. A candidate who understands the direction of the effect understands why the two things move together.
The paper returns to the interest rate as a policy variable a few questions later, where 'Dear Money' has to be recognised as a high rate of interest. The two items reward the same underlying knowledge from opposite ends.
Key facts
- Expansionary monetary policy increases the money supply — a lower policy rate, lower reserve requirements, or open-market purchases of securities.
- In IS-LM terms it shifts the LM curve rightward, so at any given level of income the money market clears at a lower rate of interest, and the lower rate then raises investment and, through the multiplier, income.
- The mechanism: excess money supply at the ruling rate leads holders to buy bonds, bond prices rise, the rate of interest falls, investment rises, and the multiplier raises income.
- The rate of interest and bond prices move inversely — that inverse relation is the hinge of the whole transmission mechanism.
- Expansionary FISCAL policy also raises income but RAISES the rate of interest, because higher income raises the transactions demand for money against an unchanged supply; this is the crowding-out mechanism.
- In a liquidity trap the LM curve is horizontal and a monetary expansion cannot lower the rate of interest further, so it does not raise income.
- Contractionary monetary policy is the mirror image — a higher policy rate, higher reserve requirements or open market sales — and it raises the rate of interest while lowering the level of income.
Study next
Common traps
- Assuming 'expansionary' means every variable rises, which makes option (c) look right. Monetary expansion raises income by LOWERING the rate of interest.
- Mixing up the monetary and fiscal cases. Both raise income; only fiscal expansion raises the rate of interest.
- Forgetting that bond prices and the rate of interest move inversely, which is the step that turns extra money into a lower rate.
- Stopping at the money market. The fall in the rate of interest is only half the chain; the rise in income comes from investment responding to it.
Macroeconomics on EPFO papers is asked at the level of direction and mechanism rather than of algebra. Expect items that name a policy and ask what happens to two variables, items that name an outcome and ask which policy produced it, and items that test a single definition such as dear money, bank rate or open market operations. The option sets are frequently built by exhausting up-and-down combinations, so partial knowledge does not narrow the field. The productive preparation is to be able to state, for each policy, which curve shifts, which way it shifts, and what happens to income and to the rate of interest as a result.
Related PYQs
EPFO_APFC_2016_Q51The term 'Dear Money' refers to
- (a) Low rate of interest on housing loans
- (b) Value of money at the recession stage
- (c) High rate of interest
- (d) Savings gained due to decrease in rate of interest on housing loans
Answer(c) High rate of interest
Tests the same variable from the other end — 'Dear Money' has to be identified as a high rate of interest, which is what a contractionary monetary policy produces.
Practice
- practice — not a real PYQ
An expansionary fiscal policy financed by borrowing will, in the IS-LM framework, generally
- (a)raise income and lower the rate of interest
- (b)raise both income and the rate of interest
- (c)lower income and raise the rate of interest
- (d)leave income and the rate of interest unchanged
Answer(b) raise both income and the rate of interest — higher government spending shifts the IS curve rightward, raising income; the higher income raises the transactions demand for money, and with the money supply unchanged the rate of interest is bid up. That rise in the rate of interest is what crowds out private investment.
- practice — not a real PYQ
When the central bank buys government securities in the open market, the immediate effect is to
- (a)reduce the reserves of commercial banks
- (b)increase the reserves of commercial banks and raise bond prices
- (c)raise the rate of interest and reduce bond prices
- (d)reduce the money supply without affecting bond prices
Answer(b) increase the reserves of commercial banks and raise bond prices — an open-market purchase pays money into the system in exchange for securities, so reserves rise and the money supply expands. Buying bids bond prices up, and since bond prices and the rate of interest move inversely, the rate of interest falls.