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Demand Management (Demand-side Policies) — Monetary Policy · Paper 2 — Free Economics SL Practice Questions

1MasteryLAQTools of monetary policy (interest rates, reserve requirements)10 marksPaper 2~15 min

In 2022, the Bank of Thailand (BOT) faced rising inflationary pressure from post-pandemic recovery in domestic demand higher global energy prices. Core inflation reached

3.2\%

, above the BOT's target range of

1

–

3\%

. Thailand's GDP growth was

2.6\%

and the unemployment rate was

1.5\%

, near its structural minimum. Commercial banks held excess reserves of

1.2\%

of deposits, above the required reserve ratio of

1.0\%

(a)

Using an AD/AS , explain how raising the policy interest rate could reduce inflation in Thailand. [4 marks]

(b)

Using the data provided, evaluate the limitations the BOT faces when using a higher policy interest rate to reduce inflation. In your answer, identify which limitation is most significant and justify your choice. [6 marks]

Solutions

2ChallengeLAQTools of monetary policy (interest rates, reserve requirements)10 marksPaper 2~15 min

In 2022, the central bank of Country X, a developed economy with low inflation (

2\%

) and moderate growth (

2.5\%

), faced a sharp rise in energy prices that pushed headline inflation to

6\%

. The central bank raised its policy interest rate from

1.5\%

4.5\%

over six months. Simultaneously, it increased the reserve requirement for commercial banks from

5\%

10\%

of deposits. Critics argue that using both tools together was an overreaction that could cause a recession, while supporters say it was necessary to anchor inflation expectations.

(a)

Explain how a higher policy interest rate is intended to reduce aggregate demand. [2 marks]

(b)

Explain how a higher reserve requirement is intended to reduce aggregate demand. [2 marks]

(c)

Evaluate whether the simultaneous use of both a higher policy interest rate and a higher reserve requirement was an appropriate response to the inflation described in the data. [6 marks]

Solutions

3ChallengeLAQTools of monetary policy (interest rates, reserve requirements)10 marksPaper 2~15 min

Country Y is a developing nation. In 2019 its central bank faced a banking crisis in which commercial banks held excess reserves equal to

15\%

of deposits but refused to lend to businesses, citing high perceived default risk. The policy interest rate had already been reduced to

0.5\%

. The central bank decided to reduce the reserve requirement from

10\%

5\%

of deposits.

(a)

Explain why reducing the reserve requirement is unlikely to increase bank lending during a banking crisis. [4 marks]

(b)

Evaluate the view that, during a banking crisis, a central bank should focus on negative interest rate policy rather than changes to reserve requirements in order to achieve its demand management objectives. [6 marks]

Solutions

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