Hint:

As crazy as the idea sounds initially it might work quite well.  The monetary stimulus may speed up economic activity by forcing businesses to raise their production levels to cater for the rise in demand for their goods services.  However in the long run having too many new blue pebbles chasing broadly the same number of products as before will simply push up the general price level, not the level of economic growth.

Amazingly such a monetary policy has been implemented on several occasions by governments, most famously perhaps by German governments in the 1920s and 1930s.  The following presentation illustrates the impact of this through a series of photographs taken at the time: German inflation

When the economy is growing we would expect to see a shift upwards in the demand for money, as private consumers and businesses seek to borrow money to finance their purchases.  This will lead to a rise in the interest rate in the economy which will reduce the demand for money and slow down economic activity.

Similarly, when the economy is operating poorly demand for loanable funds will fall and interest rates will reduce, encouraging firms and consumers to borrow more and speed up the rate of economic activity in the economy.

The supply of money will shift to the right, reducing the rate of interest in the economy - this would be an example of expansionary monetary policy.

Lowering interest rates by reducing the reserve rate (the rate of interest that central banks lend money to commercial banks), reduce the reserve requirements, allowing banks to lend money out more easily or use open market operations.  This means purchasing bonds on the open market to increase the supply of money in the economy.

Lower interest rates encourages consumers to spend more of their income and also encourages businesses to invest.  Saving, which is a substitute for consumption and investment is less profitable when interest rates are lowered.

As the video highlights contractionary monetary policy will reduce AD back to AD1 and the inflationary gap will close.  Free market economists, however, suggest that this would happen anyway, without any government policy required because of the economy's natural stabilisers.

As the video highlights eventually the economy should return to normal because over time the price of factor resources - land, labour, capital e.t.c.will fall in price, reducing the operating costs for businesses and providing an incentive for businesses to expand their output.  For example, in recession many workers will become unemployed and would be willing to work for a lower wage than previously.  With demand for money being low interest rates would also naturally fall, without the government actually making it happen.

This remark referred to a central bank action to reduce the stimulus that it has been giving the economy, once the party was in full swing and no longer required central bank help.

The importance of interest rates cannot be overstated.  As the table above shows a rise in central bank interest rates from 3% to 5%, reduces monthly disposable incomes by $ 200.  This is $ 200 that households then have to spend on goods and services.  As consumption falls firms reduce their stock levels and cut back on workers, reducing incomes and employment further.  

Higher interest rates also reduces investment levels as the opportunity cost of investing rises i.e. it becomes more expensive to borrow the money thus requiring a higher return to make the project successful.  Alternatively if the investment is to be financed from a company's savings then firms can make more money from simply placing their savings in the bank.

All of this means that manipulating interest rates is probably more effective than changes to taxation in terms of the overall impact on consumption rates.  For instance, in the example above the government would have to raise income tax rates considerably in order to reduce disposable income levels by the same amount.

The video identifies three challenges facing any central bank:

• the quality of any data they are relying on - revisions to data are commonplace and central banks cannot simply wait for the revisions to become available.
• time lags, typically 16 - 18 months between the data becoming available and the appropriate policy taking an effect.
• control of central bank is not absolute e.g. commercial banks may not pass on lower interest rates to the consumer.

By stimulating either too much or too little there is a very real risk of central banks storing up greater problems for the future.  For example, the video argues that aggressive expansionary monetary policy in the late 1970s caused even bigger problems in the early 1980s.

The multiple by which money placed in the bank is used by banks to create loanable funds.  The size of the multiplier depends on the reserve requirement e.g. 1 - reserve requirement.

$ 90 billion.  With the $10 billion bond purchase the banks must hold back, meaning that the banks can take the other $9 and lend it out to consumers and businesses.  However, each time they lend money out the bank must retain 10%, meaning that the total addition to the money supply is $9b x 10 = $90b 

$13.5 x 10 = $135 billion.

Expansionary because it will allow banks to lend out more funds.