Understanding the Limitations of Monetary Policy | CFA Level I Economics

In this lesson, we’ll discuss the limitations of monetary policy, including some of the key assumptions that can go wrong. We’ll also explore the effectiveness of monetary policy in addressing deflation and the role of quantitative easing in stimulating the economy.

Assumptions and Limitations in the Monetary Transmission Mechanism

As we learned in the last lesson, the monetary transmission mechanism describes how changes in the policy rate affect price levels and inflation. There are many assumptions in this mechanism, which means there are many places for things to go wrong. Let’s examine some of these assumptions and their limitations:

1. Long-term market interest rates may not move in the same direction as short-term interest rates

Central banks adjust the policy rate in hopes of changing market interest rates. However, long-term interest rates may not always move in the same direction as short-term interest rates. For example:

When the central bank raises the policy rate to lower inflation:

1. Short-term interest rates increase due to the direct impact on banks’ cost of funds.
2. Bond market vigilantes, who believe the central bank’s actions will slow long-term economic growth, demand more long-term bonds, causing long-term interest rates to fall.

This can lead to an increase in long-term borrowing and higher aggregate demand, which can push prices higher, rather than lowering inflation as the central bank intended.

2. The money demand curve may not always be downward sloping

Central banks affect market interest rates by adjusting the money supply. However, in extreme instances, the demand for money can become infinitely elastic, with a horizontal demand curve. In this case, further increases in money supply will not lower interest rates or affect real activity. This is known as a liquidity trap, where monetary policy becomes ineffective since it cannot affect the market interest rate. A liquidity trap is usually due to a deflationary environment.

Addressing Deflation: Challenges and Quantitative Easing

Compared to inflation, deflation is more difficult for central banks to reverse. This is because the central bank is limited to reducing the nominal policy rate to zero. Once it reaches zero, the central bank has limited ability to further stimulate the economy. In such situations, central banks may resort to quantitative easing (QE).

Under QE, central banks purchase large quantities of assets other than short-term Treasury securities, such as mortgage securities and long-term Treasury bonds. This aims to:

1. Encourage bank lending by improving banks’ balance sheets.
2. Reduce mortgage rates to revive the housing market.
3. Bring down longer-term interest rates to increase lending and economic growth.

Despite the use of QE, central banks may still struggle to pull the economy out of deflation, as seen in Japan’s case.

Reluctance of Banks to Lend Excess Reserves

Another assumption in monetary policy is that banks are always willing to lend excess reserves. However, this is not always true, as demonstrated during the 2008 financial crisis. Under extreme fear and uncertainty, many banks refused to lend even though they had access to cheap money from the Fed.

Conclusion: Limitations of Monetary Policy

Monetary policy, while a powerful tool for managing inflation and economic growth, is not without its limitations. In this lesson, we discussed four key limitations:

1. Long-term market interest rates may not move in the same direction as short-term interest rates.
2. The money demand curve may not always be downward sloping, leading to a liquidity trap.
3. Monetary policy may struggle to counter deflation, requiring the use of quantitative easing as an alternative approach.
4. Banks may be reluctant to lend excess reserves, particularly during periods of fear and uncertainty.

These limitations underscore the importance of understanding the complexities of monetary policy and the need for alternative tools, such as fiscal policy, to address economic challenges.