Evaluating Monetary Policy

Strengths of Monetary Policy

Ability to Fine Tune (Incremental increase or decrease in r)

As interest rates can be raised or decreased by small amounts, it is easier to fine tune economic activity. (it is common for interest rates to be raised or lowered by 0.25%) This means that the central bank is able to implement the smaller increases or decreases to deal with changes in the economy earlier and possibly prevent larger recessions or inflationary spirals. As a result, this can reduce the risk of large disruptions to the macroeconomic activity and can help smooth out the fluctuations in the business cycle, creating a more stable macroeconomic environment.

Short Time Lags

Monetary policy is known for its ability to be implemented quickly and adjusted as needed. Unlike fiscal policy, which often requires lengthy legislative processes and political negotiations, changes in monetary policy can be enacted swiftly by central banks. This rapid response capability is critical in times of economic volatility, allowing for timely interventions that can stabilize financial markets and influence economic conditions. For example, during sudden economic downturns, central banks can quickly lower interest rates to encourage borrowing and spending, helping to mitigate the impact of the recession.

No Crowding Out

Unlike Fiscal Policy, which may cause crowding out, Monetary policy aims to encourage business borrowing by lowering the interest rates and therefore will not cause any crowding out effect.

Possible independence from Political Decision making

In some countries, the central bank is independent of any political influence and therefore, the decision making may be removed of any political prioritise. For example, when an economy is experiencing high inflation, governments may be reluctant to raise taxes and reduce spending (contractionary fiscal policy) due to it being unpopular with voters. As an independent central bank, they can make decisions detached from political decisions, meaning they may be more effective in dealing with economic priorities.

Control Over Inflation

One of the primary objectives of monetary policy is to maintain price stability by controlling inflation. Central banks, such as the Federal Reserve in the United States, use tools like interest rate adjustments and open market operations to influence the money supply and demand. By targeting specific inflation rates, central banks help ensure that prices remain stable, which is crucial for economic predictability and planning. Stable prices reduce uncertainty, allowing businesses to invest and consumers to spend with confidence, ultimately supporting sustainable economic growth

Weaknesses of Monetary Policy

Limited effectiveness as Interest Rates get close to zero

Whilst cutting interest rates can encourage less saving and more borrowing, as interests rates get closer to 0, the effectiveness of lowering interest rates becomes less effective as the decrease may not make encourage additional borrowing and discourage savings, rendering monetary policy ineffective. For example, if interest rates are already low in an economy at say 2% and the central bank cuts interest rates to 0.5%, further cuts to interest rates towards 0% may not be effective in encouraging borrowing and reducing savings. This can contribute to a phenomenon called a "liquidity trap", described by John Maynard Keynes as the point where lowering interest rates to a certain level will not encourage additional spending or borrowing.

Reliance on Consumer and Business Confidence

Increasing or decreasing interest rates will indirectly influence the levels of consumption by households and investment by firms. Therefore, monetary policy is heavily reliant on how households and firms will respond to the changing interest rates. This differs to Fiscal Policy where governments can directly increase or decrease the spending in the economy in order to increase or decrease Aggregate Demand.

For example, during a deep recession, if consumer and business confidence is low, even a large decrease in the interest rates might not be enough to incentivise households to save less and borrow more to consume and firms to borrow more to invest. Similarly, with very high levels of inflation, uncertainty about whether the central bank can achieve low and stable inflation, may cause consumer and business confidence to decrease and despite raising interest rates, spending may increase, further worsening inflation.

Time Lags

Consumers and firms may take time to respond to the changes in interest rates and therefore the policies may take time to be effective. Most central banks set interest rates on future expectations for the economy and problems such as inflation. Therefore, if an economic event happens suddenly, central banks may be slower to respond and therefore policies take longer to be effective.

Potential for Inequality

Monetary policy, particularly through interest rate adjustments and asset purchases, can have distributional effects that may exacerbate economic inequality. For instance, lowering interest rates can inflate asset prices, benefiting those who own stocks and real estate more than those who do not. Similarly, quantitative easing can disproportionately benefit financial institutions and wealthy individuals, widening the gap between rich and poor. While the primary goal of monetary policy is economic stabilization and growth, these unintended side effects on inequality can pose social and economic challenges

Case Study 1: Expansionary Monetary Policy in the United States (2008-2015)

Introduction

The United States implemented a significant expansionary monetary policy in response to the 2008 Global Financial Crisis. The Federal Reserve (Fed) aimed to stimulate economic growth, reduce unemployment, and prevent deflation. The tools used included lowering interest rates and initiating quantitative easing (QE) programs.

Policy Measures

To counteract the severe economic downturn, the Fed slashed its benchmark interest rate (the federal funds rate) from 5.25% in 2007 to nearly 0% by December 2008. This made borrowing cheaper for businesses and consumers, encouraging investment and spending. Additionally, the Fed launched three rounds of QE, where it purchased large quantities of government bonds and mortgage-backed securities, injecting liquidity into the economy and lowering long-term interest rates.

Outcomes

The policies succeeded in achieving several macroeconomic objectives:

Economic Growth: Real GDP growth, which had contracted by 2.5% in 2009, returned to positive territory in 2010, growing by 2.6%.
Unemployment: The unemployment rate, which peaked at 10% in October 2009, steadily declined to 5% by 2015.
Inflation: While inflation remained below the Fed's 2% target for much of this period, the policies prevented deflation, which could have worsened the economic crisis.

However, critics argued that the prolonged use of expansionary policies increased income inequality by boosting asset prices and led to excessive risk-taking in financial markets.

Case Study 2: Contractionary Monetary Policy in India (2010-2013)

Introduction

India adopted contractionary monetary policy between 2010 and 2013 to combat rising inflation. Following the global recovery after the 2008 crisis, India experienced rapid economic growth, but this led to significant inflationary pressures, with consumer price inflation exceeding 10% in 2010. The Reserve Bank of India (RBI) focused on price stability to maintain macroeconomic stability.

Policy Measures

The RBI increased its benchmark interest rate, the repo rate, multiple times during this period. The rate rose from 5% in early 2010 to 8% by late 2011. These rate hikes aimed to curb excessive demand in the economy and slow inflation. Additionally, the RBI tightened liquidity by increasing the cash reserve ratio (CRR), requiring banks to hold more reserves and reducing the money supply available for lending.

Outcomes

The contractionary policy had mixed results:

Inflation: Inflation began to moderate, falling to 6.5% by early 2013, though food price inflation remained persistently high due to supply-side issues.
Economic Growth: Growth slowed significantly, from 10.3% in 2010 to 5% in 2013, as higher borrowing costs dampened investment and consumption.
Currency Stability: The tighter monetary policy helped stabilize the Indian rupee, which faced depreciation pressures during the "taper tantrum" of 2013, when the US Federal Reserve announced plans to reduce its QE program.

Critics argued that the RBI's policies disproportionately affected small businesses and rural households, as they faced higher borrowing costs and limited access to credit. Moreover, supply-side bottlenecks, such as poor infrastructure and inefficient agricultural markets, remained unaddressed.

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