Economics
Monetary Policy Effects
and Limitations
Monetary Policy Effects and Limitations
Central Bank Essential Qualities
To be effective, central banks should be independent
(i.e., free from political interference)
Operational independence: independently sets the policy rate
Target independence: sets the inflation target, measures inflation,
determines the horizon to meet the target
Not absolute; viewed as degree of independence
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Monetary Policy Effects and Limitations
Central Bank Essential Qualities
To be effective, central banks should have credibility and
transparency.
They should have credibility to follow through on their stated
intentions. Market participants know that the central bank is serious
about achieving an inflation target.
They should have transparency of the economic indicators and
other factors used to establish the interest rate setting policy (and
issue inflation reports).
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Monetary Policy Effects and Limitations
Central Bank Targets
Interest rate targeting: increase (decrease) money supply growth
when interest rates are above (below) targets
Inflation targeting: target band for inflation rate (1% to 3%)
Increase money supply growth when inflation is below target
band; decrease money supply growth when inflation is
above target band
Target inflation band > 0 to prevent deflation
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Monetary Policy Effects and Limitations
Central Bank Targets
Exchange rate targeting: used by developing countries to target a
currency exchange rate with a developed country (e.g., USD)
If the domestic currency falls relative to USD, central bank uses
foreign reserves to buy the domestic currency
Sell (buy) domestic currency when above (below) target
Central bank doesn’t react to domestic economic conditions
Result of successful exchange rate targeting is same inflation rate
in domestic economy as in targeted developed country
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Monetary Policy Effects and Limitations
Limitations of Monetary Policy (1)
Monetary policy does not always produce the intended results.
Expected inflation
If individuals and businesses believe that a decrease in money
supply will be successful, they expect lower inflation rates.
Long-term bond yields that include an inflation premium will fall,
tending to increase economic growth.
The central bank intended to slow economic activity.
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Monetary Policy Effects and Limitations
Limitations of Monetary Policy (2)
Monetary tightening may be viewed as too extreme:
Increasing the probability of a recession
Reducing long-term interest rates
Making long-term bonds more attractive
Bond market “vigilantes”
If monetary supply growth is seen as inflationary:
Higher future asset prices are expected
Increase long-term rates
Long-term bonds become relatively less attractive
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Monetary Policy Effects and Limitations
Limitations of Monetary Policy (3)
A liquidity trap may occur if the demand for money becomes
very elastic.
Liquidity trap
Individuals willingly hold more money, even without a decrease
in short-term rates.
Increasing the growth of the money supply will not decrease
short-term rates (individuals hold the money in cash balances).
It may occur with deflation, even if the money supply is expansionary.
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Monetary Policy Effects and Limitations
Limitations of Monetary Policy (4)
Deflation is more difficult for central banks than inflation. Once policy
rates are zero, there is limited ability to stimulate the economy.
Quantitative easing was used by central banks to increase the money
supply as rates were near zero (post the credit bubble collapse, 2008):
In the U.K.—large purchases of government bonds, to reduce rates
In the U.S.—large purchases of Treasuries, mortgage securities, and
other credit risky securities, to encourage lending and reduce rates
Improved banks’ B/S, shifting risk from private to public sectors
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Monetary Policy Effects and Limitations
Monetary Policy in Developing Economies
Developing countries face problems implementing monetary policy:
Without a liquid market for their government debt, open market
operations are difficult to implement.
In a rapidly developing economy, it is difficult to determine the
policy neutral rate (balancing growth and controlling inflation).
Central banks may lack credibility and independence.
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Monetary Policy Effects and Limitations
Interaction of Monetary and Fiscal Policy
Both policies may either expansionary or contractionary.
Four scenarios:
1. Expansionary fiscal and monetary policy
There is highly expansionary impact with lower interest rates, and
both private and public sectors expand.
2. Contractionary fiscal and monetary policy
There is lower aggregate demand and GDP. There are higher
interest rates, and both private and public sectors contract.
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Monetary Policy Effects and Limitations
Interaction of Monetary and Fiscal Policy
3. Expansionary fiscal, contractionary monetary policy
There is higher aggregate demand due to fiscal policy. There are
higher interest rates due to increased government borrowing and
tight monetary policy.
4. Contractionary fiscal, expansionary monetary policy
Interest rates fall from decreased government borrowing and the
expansion of the money supply. Consumption and output increase,
and the private sector grows as a result of lower interest rates.
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