In order to combat economic recessions and stimulate economic recovery, monetary policy is normally invoked as the tool of choice by the Federal Reserve to move toward restoring the country’s recovery. In the short run, monetary policy is expected to have an effect on aggregate demand by increasing the demand to promote increased production. Monetary policy normally has no effect on the money supply over the long run; however, it is one of the most effective tools to use during the short run to help stabilize prices, work toward maximum employment, and level interest rates to carry through for the long run.
It has been shown to be effective in the past for stimulating the recovery by expanding the country’s money supply. The central bank, under the control of the Federal Reserve will generally use one or all of the three tools they have available to use when trying to stimulate the economy:
1. Through Open Market Operations, the Central Bank purchases government bonds (national debt) to increase the monetary base
2. Changing credit restrictions where the Central Bank may reduce the required reserve amount of cash that banks must have on hand
3. Reducing the overnight lending rate (prime rate) for loans to banks
A brief example of the deployment of monetary policy recently is in January of this year when the Brazilian FED indicated that it is recovering slower than expected and anticipates that additional monetary policy would fail to boost economic growth (Malinowski & Colitt). The reason for the lack of domestic economic activity could be due to supply limitations. Insofar as this is the case, monetary policy by no means solves the issue since it is primarily a device leveraged to control supply.
A balance must be maintained when applying monetary policy because if the economy grows too fast, it could be placed into an inflationary period where too much money is available within the economy. The Taylor Rule is utilized to help stabilize the economy in response to inflation to help stabilize prices and maintain maximum employment. When the rate of inflation rises upon a predetermined target rate to a particular level, the Federal Bank can be expected to respond by raising interest rates and vice versa. The Taylor Rule was just implemented in Brazil on January 15 of 2013 bringing consumer price increases to the 4.5 percent target (Malinowski & Colitt). This is clearly juxtaposed to Mexico and Chile where inflation is slowing. In the fourth quarter of 2012 both Mexico and Chile failed to keep control over inflation rates as unemployment skyrocketed and alongside a decrease in the supply of goods (Malinowski & Colitt).
While monetary policy is considered a faster response to put the economy back on track than fiscal policy, which can be a drawn out process with approvals from the legislative branch of the government, it may be prone to encountering lags in seeing its intended effects. These lags can be difficult to predict and can vary in length of time. Meanwhile output and inflation rates may have changed which will now precipitate the need for adjustments to the monetary policies that have been set in place. Therefore, when the Federal Reserve institutes a monetary policy action, they need to anticipate its effects in the future.
In the current financial crisis in the United States, there has been speculation that monetary policy has failed to reestablish transmission mechanisms that were expected to occur to aid in stimulating the economy. Transmission mechanisms are the effects that are expected to occur on “interest rates, exchange rates, equity and real estate prices, bank lending, and firm balance sheets” (Ireland, 2006). The expected effects of the monetary policies that were implemented by the Federal Reserve for the country’s economy were that interest rates would be lower, which in turn would encourage consumers to make large purchases that would require loans of the use of credit cards.
In terms of the shortcomings of monetary policy in the Brazilian scenario, the policy failed to stimulate economic output and productivity. Demand side economic policies can help encourage consumption but supply side policies need to compliment the policies. For example, the policy relies on a predictable economy, but the major emerging market proved to be dynamic as all economies are. Food price shocks and consumer demand caused inflation to accelerate faster than economic predictions. Insofar as monetary policy fails to account for variable change, it will inevitably succumb to the dynamic pressures of the market.
It was expected that the housing market would recover after suffering a severe decrease of real estate values and more people would purchase homes. The construction industry should have also recovered more with an expected demand for more homes to be built. Instead, the banks instituted a credit crunch where it has become increasingly difficult for consumers to obtain financing as requirements have been raised for them to meet. Banks have hoarded the money that became available through the efforts of quantitative easing that were instituted by the government purchasing securities to build their money base instead of what it in which it was intended.
Monetary policy can be an effective way to stimulate the economy provided all actors respond in a responsible manner. This cannot always be expected to happen, and when it does not, flexibility needs to occur to make the necessary adjustments to the policies. If the three normal tools of monetary policy fail, the Federal Reserve has other options such as liquidity provision where it can auction off securities to improve liquidity.
- Clark, Todd. (2013). Hot Topic: What is the Taylor Rule and What is it Good (and not Good) For? Forefront. Retrieved from http://www.clevelandfed.org
- Federal Reserve Bank of San Francisco. (2011). About the Fed. Retrieved from http://www.frbsf.org/publications/federalreserve/monetary/affect.html
- Federal Reserve. (n.d.). Monetary Policy Basics. Retrieved from http://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy/
- Ireland, Peter. (2006). The Monetary Transmission Mechanism. Retrieved from http://www.bos.frb.org/economic/wp/wp2006/wp0601.htm
- Malinowski, M., & Colitt, R. (2013). Brazil says monetary policy not best tool to lift growth now. BloomBerg, Retrieved from http://www.bloomberg.com/news/print/2013-01-24/brazil-says-monetary-policy-not-best-tool-to-lift-growth-now-1-.html