Stilwell – Monetary policy

Frank Stilwell describes some of the problems which may be encountered when using monetary policy in this extract from pp.297-299 of Stilwell, F. J. B. (2012). Political economy : the contest of economic ideas (3rd ed.). Australia: Oxford University Press.

[D]evelopments since Keynes’s time bear heavily on how monetary policy can actually be applied. First, governments often do not have the policy instruments directly at their disposal. Monetary policy is commonly in the hands of central banks that have a considerable degree of independence from governments…So, when economic commentators talk about the policy mix between fiscal and monetary policies, it is important to remember that the responsible authorities are not necessarily the same. Sometimes they are not even working comfortably in tandem…

A second consideration is how monetary policy has been constrained by the process of financial deregulation that has taken place in many nations… some of the direct controls over financial institutions that were previously exercised by governments and/or central banks have been relinquished…

The main effect of deregulation, as far as monetary policy is concerned, has been to leave the central monetary authority with indirect control over the general level of interest rates as its main, if not sole, remaining policy instrument…

As with fiscal policy, there are potential pitfalls. Indeed, the issue of timing is more crucial in the case of monetary policy. There are usually long and uncertain time lags between the policy process and its economic effects. It may be some time before the monetary authority sees the need for a policy adjustment (the recognition lag), and more time may elapse before it decides which particular adjustment to monetary policy is appropriate (the implementation lag). There may then be a significant period during which consumers and business people decide how to modify their plans for consumption and investment spending (the decision lag) and yet more time before those decisions affect the output of goods and services produced (the impact lag). By that time, the prevailing national economic conditions may be markedly different. In the worst-case scenario, a supposedly countercyclical policy can turn out to accentuate the amplitude of the cycle.

Monetary policy also tends to have a non-symmetrical impact. It is most powerful as a contractionary measure. Higher interest rates can be relied on to depress the level of economic activity. Raising the cost of borrowing money has a particularly strong impact on investment by small businesses and on home loans (and, therefore, on the construction industry). Monetary policy usually works less well in the opposite direction…

Finally, the impact of monetary policy is not selective. An increase in interest rates usually has depressing effects on investment levels throughout the economy. This can be problematic because different regions or industries in a nation may be experiencing quite different economic conditions…An interest rate rise designed to choke off inflationary pressures in booming regions may send other regions into recession. The same may occur with fiscal policy, but in that case there is the possibility of targeting public expenditures at particular regions or industry sectors according to the prevailing economic conditions in those regions or sectors. In the case of monetary policy, no such possibility exists.

Commentary added 16th October 2014