Is monetary policy alone enough to stimulate economic recovery?

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Vivian Lau Shi Ni's picture

Monetary policy, loosely defined, is the management of money supply in a country by a central bank or currency board in order to achieve goals of economic growth and stability. Before the currency peg to gold in the Bretton Woods system collapsed in the 1970s, monetary policy was primarily executed through the control of money supply rather than interest rates as monetary authorities had a monopoly of currency issuance. When the US$ was agreed upon as a common unit of currency exchange across nations, money supply in the world became liberalized as it was no longer pegged to a fixed resource. Over time, as the world became more globalized and interconnected through technology improvements, the development of sophisticated financial instruments allowed capital for investments and speculation to be quickly and easily shifted from one country to another. This phenomenon makes it difficult for central banks to execute monetary policy in times of crisis through controlling the country’s money supply. Therefore, many central banks today choose to control interest rates instead.

There are two techniques employed by central banks that allow them to influence interest rates. Firstly, central banks engage in open market operations, which simply put, mean that they buy and sell bonds or securities in financial markets to withdraw or inject liquidity in the economy. This process operates based on demand and supply theory. For example, when there is an economic recession such as the recent global recession triggered by the 2008/2009 United States subprime mortgage crisis, a central bank may decide to conduct expansionary monetary

policy by lowering interest rates. Thus, the central bank would begin to buy bonds either from the banking system or the non bank public such as corporations. This action increases the demand for bonds and subsequently the price of bonds, which lowers the returns of investment (interest rate) to another bond buyer, and reduces the opportunity cost of holding liquid money. To bond sellers (usually corporations), the lower interest rate is beneficial as previous investment projects which had lower payoffs are now viable as the cost of borrowing money to fund these investment projects which expands their business capacities is now lower. Thus, this increase in investment and liquidity would generate economic growth through the multiplier effect. Similarly, consumption would also increase as it is now cheaper to borrow money for purchases of durable goods.

Secondly, central banks influence the market interest rates through a change in the discount rate1. During a recession, central banks may decide to reduce discount rates to encourage commercial banks to continue lending to firms and individuals for investments. This is because the principal-agent problem (caused by asymmetric information2) underlying all lender-borrower relationships is further exacerbated in times of economic uncertainty, making it much more difficult for commercial banks to assess the value and riskiness of a loan. As commercial banks are generally conservative, there is a very small margin for error. Thus, commercial banks may then decide to tighten their credit policy in times of uncertainty by increasing interest rates or reducing the amount of loans made to borrowers in order to cushion against the higher risks and protect their balance sheets (to prevent insolvency). This decision is detrimental to the economy as it obstructs funding for investments that would lead to real productivity growth in firms and reduces money supply in the economy because it reduces the money multiplier by trapping the liquidity within the bank reserves. However, when the central bank reduces the discount rate, it sends a signal to commercial banks that they can continue normal lending operations. Commercial banks worry less about insolvency issues as they can now borrow money from the central bank at a cheaper cost (discount rate) to finance their loans and earn the interest difference. This ability to borrow at lower discount rates also signifies that the commercial banks can charge lower interest rates to borrowers in order to earn the same interest difference as before. Thus, by lowering discount rates, the central bank lowers market interest rates as well and stimulates economic growth by lowering the cost of borrowing for firms and individuals which leads to increased investment and consumption.

While monetary policy sounds like an amazing policy tool in our previous discussion, we must now ask ourselves one question: Is monetary policy alone really enough to stimulate economic recovery? The answer is no. I do not mean that monetary policy is ineffective during economic crises; merely that it is not enough. Let me explain my reasons in the next section of this essay. From here on, I will refer to economic crises as those caused by the collapse of the financial sector in the economy.

First and foremost, we must consider the aim of executing a monetary policy expansion during a crisis. Ultimately, policymakers use this policy tool to restore equilibrium in the economy. The crucial question here is this: Where is the true equilibrium? What is the optimal interest rate? During normal periods of economic growth, we can safely assume that the economy fluctuates within a narrow range near the true economic equilibrium level. However, pre-crisis periods are often foreshadowed by a weakness in the financial sector, such as a sustained high increase in asset prices due to speculation, bullish behavior or principal-agent problems. As it is difficult to predict or identify such problems before it accumulates to a sufficient degree to affect the economy, these pre-crisis periods distort the market’s perception of the true economic equilibrium, making it difficult for economists to estimate the true equilibrium level based on this historical data during the crisis period.

Additionally, using the recent financial crisis of the housing bubble burst in United States as an example, we observe that while the Federal Reserve carried out two rounds of expansionary monetary policy, Quantity Easing One (QE1) and Quantity Easing Two (QE2), there has been many debates about whether QE2 was a correct decision to make, whether it was made at the correct time, and whether a third round of Quantity Easing was required. From this, we see that there is a fine line between correction and over-correcting (whereby the latter is undesirable) and that the timing of both injection and withdrawal of liquidity is essential in achieving the desired equilibrium level. Hence, not only does monetary policy have a small margin of error, it is also easy to mismanage as the true equilibrium is difficult to estimate.

Next, we must consider the time lag limitation of monetary policy. Although monetary policy can be adjusted and implemented faster through open market operations and through lowering discount rates as compared to fiscal policy, it has a longer response lag. Even though market interest rates can change overnight, consumption behaviour, decisions, and investment plans take time to adapt to the new interest rate. As companies generally plan their investments across several years, it will take them some time to re-organize their investment plans in order to respond to the interest rate changes. Until firms and consumers change their consumption or investment spending to affect sales and earnings, there is little policy effect to be seen, unlike in a fiscal expansion where the impact is more direct and observable. This limitation of time lag further aggravates the difficulty in estimating whether the true equilibrium level in the economy is reached with that degree of monetary policy expansion.

Lastly, the effectiveness of the monetary policy depends on the type of economy. The impossible trinity theory states that we can only choose two out of three policy tools (other than fiscal policy); exchange rate autonomy, monetary autonomy and capital control. In a large open economy like the United States whereby the major component driving economic growth is domestic consumption and investment, monetary autonomy (and hence monetary policy) is more effective than exchange rate autonomy in regulating economic growth. In contrast, a small open economy like Singapore (which is heavily dependent on its trade industry) would prefer to have autonomy over its exchange rate rather than its interest rate because the contribution of domestic consumption and investment to its economic growth is trivial compared to its trade volumes. Thus, a monetary expansion has a greater impact on a large economy than a small open economy.

In conclusion, while monetary policy is an effective tool to stimulate economic recovery, or minimally, prevent the crisis from worsening, it should be reinforced by other policy tools such as fiscal policy. Due to the sensitive nature of monetary policy and the type of economy it works best on, policymakers should not solely rely on monetary policy but choose the best policy mix to govern their country.


  1. The discount rate is the interest rate charged to commercial banks who borrow money from the central bank
  2. A principal-agent problem occurs when there is asymmetric information, where one party in the borrower-lender relationship possess more information than the other, thus allowing cheating (which incurs monetary losses) to occur.
  3. Case. Fair. Oster. (2009). Principles of Macro-economics. 9th ed. United States of America: Pearson International Edition. p303.
  4. Frederic S. Mishkin (2006). The Economics of Money, Banking, and Financial Markets. 8th ed. United States of America: Pearson International Edition. p348-351.
  5. Mishkin, Frederic S., (2009). Is Monetary Policy Effective During Financial Crisis?. NBER , [Online]. Working Paper No. 14678, p1-12. Available at: [Accessed 10 February 2012].
  6. Guido Tabellini. (2008). Why Central Banking Is No Longer Boring. [ONLINE] Available at: [Accessed 01 February 12].
  7. Paul Yip Sau Leung (2011). China's Exchange Rate System Reform. Singapore: World Scientific. p277-389.