Limitations of Monetary Policy during Recessions

Very Hard Macroeconomics Monetary And Fiscal Policy

In the context of macroeconomic theory, consider the effectiveness of monetary policy in combating recessionary gaps. In a severe economic downturn, the central bank may decide to implement an expansionary monetary policy by reducing interest rates and increasing the money supply. However, during periods of exceptionally low interest rates, central banks may encounter difficulties in stimulating economic growth through this traditional channel.

Which of the following statements best describes a potential limitation of monetary policy under these conditions?

Lower interest rates might lead to a liquidity trap, hindering further investment and consumption.

Expansionary monetary policy can always increase the money supply, regardless of existing liquidity constraints.

Increased money supply guarantees inflation, which will automatically stimulate economic growth.

Hint

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