"economics"exercise:Policy interest rate

B is correct. The monetary transmission mechanism is the process whereby a central bank’s interest rate gets transmitted through the economy and ultimately affects the rate of increase of prices (inflation). 

A is incorrect because, although policy rate actions do transmit through the economy by affecting total demand, this influence on total demand is an intermediate effect that drives subsequent domestic inflationary pressure. In effect, policy rate actions ultimately impact inflation through the avenue of total demand. 

C is incorrect because although policy rate actions do transmit through the economy through the channel of market rates (both short-term and long-term interest rates), this is just one of four channels and multiple interconnected channel relationships that impacts total demand. In effect, policy rate actions ultimately impact inflation through the channel of market interest rates (including long-term interest rates).

C is correct. A real trend rate of growth of 1%, coupled with 3% long-run expected inflation, suggests a 4% neutral rate of interest that neither spurs on nor slows down the underlying economy. The 3% policy rate is less than the 4% neutral rate of interest. When the policy rate is below the neutral rate, monetary policy is described as expansionary.

 A is incorrect because, with a neutral policy stance, the central bank’s policy rate would be equal to the neutral rate. In this case, the policy rate of 3% is less than the neutral rate of 4% (1% trend growth plus 3% long-run inflation expectation), which is expansionary (not neutral). 

B is incorrect because, with a contractionary policy stance, the central bank’s policy rate would be greater than the neutral rate. In this case, the policy rate of 3% is less than the neutral rate of 4% (1% trend growth plus 3% long-run inflation expectation), which is expansionary (not contractionary).