Monetary Policy Evaluation

Unit 12.1 - Lesson 3

Learning outcomes:
● Evaluate the effectiveness of monetary policy through consideration of factors
including the independence of the central bank, the ability to adjust interest
rates incrementally, ability to implement changes in interest rates relatively
quickly, time lags, limited effectiveness in increasing aggregate demand if the
economy is in a deep recession and conflict among other macroeconomic
objectives.
● Explain that central banks of certain countries, rather than focusing on
maintenance of both full employment and low rate of inflation, are guided in
their monetary policy objective to inflation target.
Stimulating Growth During Recession - STRENGTHS
Speed: No Politics:

● Implemented as soon as problem is ● Central Banks are independent of

identified
Control:
● Ability to adjust the money supply
more discretely and finely than fiscal
policy.
● Monetary Policy is more finely
calibrated to address the problem at
hand.
the government therefore decisions
are not influenced by political
motives.
No Crowding-out:
● Fiscal Policy requiring government
borrowing drives up interest rates
and argued crowds out economic
growth.
● Monetary Policy by lowering interest
rates avoids this.
Stimulating Growth During Recession - WEAKNESSES
Investors Reluctant to Borrow

● Deep recessions - consumer and investor confidence is low.

● Fearful of losing jobs cut back on large purchases, saving for “rainy day”.
● Firms aware of this decrease in consumer confidence
○ Reduce output
○ Reduces demand for new investment funds
● Thus reducing interest rates do not stimulate increases in AD

Example Japan’s “lost decade” from 1991 to 2010

Time Lags

● While quick to implement it takes time to impact the economy.

Stimulating Growth During Recession - WEAKNESSES
Changes in Elasticity of Demand for Investment

● Expansionary Monetary Policy results in a decrease in interest rate.

○ If economy is near full employment - demand for money is relatively elastic.
■ Businesses are willing to take advantage of the lower cost of borrowing.
■ Therefore the quantity demanded of money will be greater.
○ If economy is in a typical or deep recession - demand for money is relatively
inelastic.
■ Businesses are not as willing to take advantage of lower cost of
borrowing.
■ Therefore the quantity demanded of money will be less - resulting in a
smaller increase in investment spending.
Inflation Targeting - Strengths
● Politicians are reluctant to implement Contractionary Fiscal Policy to combat
inflation for fear of losing votes.
● Central Banks can take direct action to control inflation without political constraint.
● Monitor CPI, PPI GDP Deflator and many more to assess inflation risk.
● Ability to increase or decrease interest rates incrementally to ensure they match
price increases.
● Able to enact policies that are deemed by voters as bad though are necessary.
Removes political implications from voters.
○ Fed Reserve under Paul Volker in 1979 pushed IR to nearly 20% attempting
to dampen high inflation of the late 1970’s.
○ Recession that resulted was long - high unemployment & political turmoil.
○ Successful in reducing inflation - 30 years of IR around or below 5%
Inflation Targeting - Weaknesses
Time lags during high inflation

● Though it can be enacted quickly it can take several months of high interest for
investors and consumers to change consumption and investment behavior.

Ineffective against Cost-Push Inflation

● Effective to reduce demand-pull inflation

● Relatively powerless in tackling cost-push inflation
○ Increase IR may decrease price levels
■ Possibly deepen a recession - decreasing RGDP & increasing
unemployment
○ Decrease IR - increase AD
■ Would not harm RGDP, but may lead to inflationary spiral
Exchange Rate Management
When a country raises or lowers it IR, it signals depositors and investors that banks
are paying different rates of interest.

Higher Interest Rates Lower Interest Rates

● Attract foreign depositers and
investors
● Foreigners must exchange or buy the
local currency.
● This capital inflow increases the
Demand for the currency
● Drives up the value of the currency -
Appreciates the currency
● Opposite occurs
● Capital outflows decreases the
Demand for the currency
● Drives down the value of the
currency - Depreciates the
currency
 Conflicting Goals
Increased Inflation
Expansionary
Monetary Policy growth, lower But
unemployment Lower Exchange Rate
= expensive imports

Reduced growth,
increased
Contractionary Reduced unemployment
Monetary Policy Inflation But

Higher exchange rate =

reduction in exports