What is the effect of monetary policy on interest rates?

• A. Expansionary policy lowers policy rates and stimulates growth; contractionary policy raises rates to curb inflation.
• B. Expansionary policy raises policy rates to stimulate growth; contractionary policy lowers rates to curb inflation.
• C. Monetary policy has no effect on interest rates.
• D. Inflation determines rates but policy doesn't.

Answer: (A)

Monetary policy steers borrowing costs through the central bank’s policy rate and the liquidity available in the banking system. When the central bank wants to boost activity, it lowers the policy rate and injects liquidity, which lowers short-term borrowing costs and often pulls down other interest rates as well. This makes loans cheaper, encourages households and businesses to borrow and spend, and helps stimulate growth. When inflation is a concern, the central bank tightens policy by raising the policy rate and reducing liquidity, which raises borrowing costs and cools demand, helping to curb inflation. The described effect—expansionary policy lowering policy rates to stimulate growth and contractionary policy raising rates to curb inflation—best matches how monetary policy influences interest rates. The other statements misstate the direction of rate changes or claim policy has no effect on rates.