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So, it seems like I can simply manipulate my entire economy just by
changing the interest rate. Isn’t that convenient and magical? Well,
sort of but there are problems. So, let’s evaluate if that monetary
policy is really as magical as it seems. The first issue we discuss is
that of sentiments. Sentiments could affect the workings of monetary
policy. Let’s say you are trying to enact an expansionary monetary policy.
You lower interest rates and hope to see X minus N increases. Well, it
may but by how much? Let’s say you already have a recession going on,
people feel like crap already. Who is going to buy a car in this climate?
So, even if you lower interest rates say from 2% to 1% and there is already
a huge, huge drop in the world of economics, people are not going to buy
a car just because of that. C may simply not increase. Same for I. Now,
even though there are more profitable projects out there but simply
because the investment climate is very bad and the fact that investors
are simply risk averse in this kind of climate, they will not invest unless
there is a huge obvious profit margin there. We can express this as a
rather steep MEI, Marginal Efficiency of Investment. Even though interest
rates change, there isn’t much change in the level of investment. Hence,
sentiments play a part in the effectiveness of monetary policies.