Effectiveness of Monetary Policy
Monetary Policy Pros and Cons
Strengths of Monetary Policy
#1 Quick implementation
- Monetary policy can yield results relatively fast, and it is easy to implement. This is because it has tight control over commercial banks.
- For instance, if the Central Bank decides to increase (decrease) the money supply, they can reduce (raise) the minimal reserve requirement ratio of commercial banks, and the impact will be immediately felt in the economy.
- The Central Bank operates independently from the rest of the government bodies that may have political constraints. Hence, they are free to pursue interventions that may not be popular, but may yield better results in the longer haul.
#3 No crowding out of investment
- Unlike fiscal policy, monetary policy does not have any crowding out effect on the private sector investment. This is because the intervention does not involve borrowing that may adversely impact the supply of loanable funds.
Weaknesses of Monetary Policy
#1 Less effective in recession
- It is less effective at times of recession. This is because during deep recession, the demand for money may become perfectly elastic. This in turn limits how much interest rate can fall.
- As such, it means that the additional money supply may not necessarily translate into higher demand, but may be hoarded for speculative purposes.
#2 General and not localized impact
- It is a broad-based tool, and it is not designed to target specific industry to spur growth.
#3 Destabilizing imports and exports
- When the Central Bank reduces the money supply, the interest rates in the economy will increase. In turn, this will attract capital from abroad looking to invest in high interest yielding assets. However, these investors will need to convert their foreign currencies to local currencies before they can invest. This will inadvertently increase the exchange rate, and it will make exports less attractive.
- When the Central Bank decreases the money supply, the interest rates in the economy will fall. In turn, this will entice capital outflow, as investors withdraw funds to invest in higher yielding assets elsewhere. To do so, investors will first liquidate their current holdings, and convert them to other foreign currencies. This will decrease the exchange rate, and this in turn will make imports to become more expensive.
#4 Time lags
- Although monetary policy can be implemented relatively fast, but the actual impact on Aggregate Demand takes time and result can be variable.
- The major effects of a change in policy on growth in the overall production of goods and services usually are felt within three months to two years. And the effects on inflation tend to involve even longer lags, perhaps one to three years, or more.