Is monetary policy alone enough to stimulate economic recovery?

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Kai Ho Chong's picture

Money policy is one branch of macroeconomic policies using the interest rate or money supply to pursue the goals of sustained economic growth and stability. In times of a financial crisis, however, when economic stimulus becomes the top policy objec­tive, a heated debate is surrounded around the effectiveness of monetary policy in such an exceptional economic circumstance; and it has remained unsettled thanks to a lack of occasions to test the theories empirically. This essay attempts to examine the use of monetary policy in a financial crisis; and for a better understanding conven­tional monetary policy would first be introduced before discussing its revisions during economic downtimes. Other policy alternatives and some further considerations will also be highlighted to shed some light on whether monetary policy alone could pro­vide a sufficient stimulus for economic recovery, a question to be addressed towards the end of the essay

   I.               Conventional monetary policy: the mechanism

In most countries, monetary authorities adopt the Taylor-rule type monetary policy by targeting the short-term nominal interest rate1. The interest rate can alter the macroeconomic condition as it represents the cost of consumption and investment activities in an economy. When the growth of national output declines or inflation falls short of the desired rate, the interest rate should be lowered to reduce the cost of household’s and firm’s financing, so as to stimulate the aggregate demand. One the other hand, raising the interest rate could avoid overheating and lessen inflationary pressure by making saving, which increases future income and consumption, a more favourable option than current consumption and investment (Dotsey, 2010). In sum, monetary policy counterbalances and smoothes out fluctuations in economic condition around its most efficient level.

   II.               Why might conventional monetary policy fail during financial crises?

As mentioned conventional monetary policy works through controlling the nominal interest rate2. But what does matter for consumption and investment decisions is the real interest rate3. Hence ultimately monetary authorities should target a real interest rate which generates the optimal inter-temporal mix of consumption, saving and invest­ment.

The relationship between nominal and real interest rates could be approximated by the Fisher equation, which equates nominal interest rate to the sum of real interest rate and expected inflation rate. Thus a lower real interest rate could be achieved by reducing the nominal interest rate4. During recessions, a negative nominal interest rate might be desirable to give a low enough real interest rate to induce sufficient current expenditure, but it is not feasible as the nominal interest rate has a zero lower bound56. In this case, the economy would enter into a liquidity trap7, where conventional mone­tary policy fails to stimulate aggregate demand by further reducing the (nominal) interest rate (Dotsey, 2010).

III.               Unconventional monetary policies

The failure of conventional monetary policy during economic downtimes does not leave the monetary authority with no policy options; but rather policy remedies would be unconventional. In this regard, two policy tools are often discussed – expectation management and quantitative easing (QE).8

(A) Expectation management

A natural extension of the discussion of the Fisher equation in unconventional policy options would be working on the last variable of the equation, that is, the expected inflation rate. As expected inflation is associated with the outlook of the economy9, monetary authority could affect the inflation expectation by communicating with the public its future interest rate policy10. In particular, it should convince the public of a lower-than-normal nominal interest rate after the recession period, so that a higher national output and thus inflation rate would be expected, realising a lower real inter­est rate at present (Dotsey, 2010). A higher expected future output would also affect the mass psychology of the economy where optimistic individuals are more willing to consume and invest11 (Dotsey, 2010). Moreover, as Bernanke et al. (2004) suggest, the commitment to a low future short-term interest rate policy could lower the current long-term interest rate12, which has a more direct relationship with private borrowing and investment. Thus shaping the public expectation of the future path of short-term interest rates could be a viable policy option. This approach of economic stimulation, however, would require the economy to tolerate a higher future inflation rate, given a guaranteed future policy path of lower-than-normal interest rate (Dotsey, 2010).

(B)  Quantitative easing

Quantitative easing (QE) refers to the further injections of money into the economy when the nominal interest rate has essentially reached its zero bound. Instead of the nominal interest rate, QE could possibly work through a fiscal channel where mone­tary injections would lessen the budget constraint of the government, allowing tax reduc­tions and increased government spending which in term stimulate aggregate de­mand (Bernanke et al., 2004). More subtly as growth in money supply has been histori­cally correlated positively with inflation13, QE might generate inflation expecta­tion, complementing the expectation management approach as discussed above (Bernanke et al., 2004).

    IV.               Fiscal policy: an alternative policy option

Another set of macroeconomic policy often contrasted with monetary policy is the fiscal policy, which uses government expenditure and taxation as policy tools. Raising government expenditure could stimulate economic recovery as it constitutes part of the aggregate demand for national output, while tax cuts or benefits could induce more private consumption14 and investment spending15. These mechanisms are not interrupted by the liquidity trap as the interest rate is not an intermediate variable16. But some government expenditure, such as infrastructural projects, might take years to be realised, hence not having an immediate effect on the economy; and policies of this type would worsen the government’s budget position, which means a debt that has to be repaid at some time in the future, by tax-payers or the general public.

V.               Further considerations

There are at least two further considerations worth highlighting. First, the causes and the nature of a financial crisis should be examined to allow specific monetary policy, or policies in general, to tackle the problem at its roots. In the late-2000s financial crisis, for example, the Fed conducted large-scale purchases of agency mortgage-backed securities (MBS) to reduce residential mortgage rates, easing the difficult housing market, the asset bubble in which is said to be one of the causes of the crisis (Kohn, 2009; Mishkin, 2011).17

The second consideration would be the characteristics of an economy which might call for a different monetary policy in an economic crisis. Considering a small open economy where a sizable portion of economic activities are dependent on foreign trades and investment, raising the interest rate during economic downtimes could, theoreti­cally speaking, maintain export competitiveness, minimise capital outflows, and achieve currency stabilisation. This may therefore justify the IMF’s policy prescrip­tions of monetary tightening in the Asian Financial Crisis (Karunatilleka, 1999).18

 VI.               Conclusion: Is monetary policy alone enough to stimulate economic recovery?

The claim that monetary policy alone is enough to stimulate economic recovery is a bold one. It requires the sole use of monetary policy, and no others. As discussed in Section II, conventional monetary policy is ineffective in a financial crisis due to the presence of the liquidity trap; hence for any monetary policy to work it must be unconven­tional. But such policies do not come without a cost – policies such as expecta­tion management and quantitative easing are likely to leave the economy with a higher rate of inflation in the future19. Thus theoretically if the economy is willing to tolerate a higher future inflation, monetary policy could achieve the intended goal of economic recovery without other policy supplements; otherwise other remedies should be included in the policy package as well.

It should be noted moreover that credibility is a prerequisite for any success of uncon­ventional monetary policies. It is because to a large extent these policies work through altering people’s present behaviour based on their expectation of the future economic condition created by a guaranteed lower-than-normal future short-term interest rate, for instance20. Thus if the public expect the monetary authority to return to the normal policy when the recession is over, the unconventional policies would fail to stimulate economic activities at the first place (Dotsey, 2010)2122. This would compound the difficulty in the effective implementation of unconventional monetary policies.

After all, there remains no general consensus what makes the best policy in times of a financial crisis. For one thing, the relationships among economic variables are so complicated that it involves considerable difficulty in assessing the effectiveness of a particular policy. For another, the nature of a financial crisis and national characteris­tics may be so different from one another that attention has to be given to the specific problems in each circumstance; and hence no particular policy, be it monetary or fiscal, makes the best policy response in all crises and all countries. Historically, during economic downtimes both monetary and fiscal policies are adopted to bring the economy out of the recession. One interpretation of this is that they are believed to be most effective when used together.


  1.  In the United States, for example, the Federal Open Market Committee (FOMC) sets the target federal funds rate, and conducts open market operations in the market of government securities for its achievement (Dotsey, 2010; Kohn, 2009).
  2. For instance, in late 2007 when the U.S. economy showed signs of weakness, the FOMC started its aggressive reduction in federal funds rate to 2 percent by the spring of 2008 (Bernanke, 2009).
  3. at least for most people who are rational enough not to count changes in the general price level as the real cost or return of financing, a situation known as money illusion
  4. This holds mathematically by keeping the inflation rate constant, or less restrictively having the drop in expected inflation rate lower than that in the nominal interest rate.
  5. This is because any negative rate would enable money to better perform the function as a store of wealth than a bank deposit (which gives negative nominal return), so people would hoard their money and are unwilling to lend (Bernanke, Reinhart, & Sack, 2004; Dotsey, 2010).
  6. Since December 2008, the federal funds rate has been “essentially zero” (Bernanke, 2009), and no further reduction has been made to the target rate hereafter.
  7. More technically, liquidity trap refers to a situation where injections of money by the monetary authority fail to reduce the nominal interest rate, which is zero or near-zero, and are therefore ineffective to stimulate economic activities, and have an effect on inflation (Dotsey, 2010).
  8. A third unconventional monetary policy alternative which is of some relevance and academic interest would be price-level targeting, which uses price, instead of interest rate, as the policy objective. This approach, however, is relatively new and has never been adopted in practice, thus given the constraint of word limit it would not be discussed here. See Dotsey (2010) (pp.13-14) and Mishkin (2011) (pp.34-36) for more detailed discussions.
  9.  A higher level of future national output would generate inflationary pressure, so the current inflation expectation would be adjusted upward, and vice versa.
  10. An example of communication policies would be the FOMC policy statements in the U.S., and an event-study analysis by Bernanke et al. (2004) has confirmed their substantial impact on market expectations of future policy.
  11. or minimise their reduction in times of recessions
  12. as the long-term interest rate is determined by the path of short-term interest rates, both the current and expected future ones
  13. It could also be proved mathematically by the quantity theory of money.
  14. due to increased after-tax income (in the case of personal income tax cuts)
  15. The government could enough new investment by raising the depreciation allowance, so that firms could expense more of their investment costs to enjoy the tax benefits, increasing the after-tax return on new investments. For example the maximum allowance for equipment acquired in 2009 was raised to $250,000 by the American Recovery and Reinvestment Act (Elmendorf , 2010).
  16. This is theoretically sound in an IS/LM framework. Also verifiable in the same framework, increase in government spending on investment projects would not “crowd out” private investments when the economy is in a liquidity trap.
  17. Some authors, such as Tassey (2011), argue the late-2000s financial crisis has revealed the longer term problem of underinvestment in physical, intellectual and capital in the United States. Therefore policy remedies should be directed at developing a technology-based growth strategy to sustain the long-term productivity growth.
  18. The IMF’s action, however, is not without criticism. Critics argue against the effectiveness of high interest rates in stabilising the currency in times of a credit crunch. For a further discussion see Karunatilleka (1999) (pp.32-33).
  19. Price-level targeting is claimed to be free from such a problem (Mishkin, 2011).
  20. As for QE, the monetary authority should convince the public of its intention to retain some part of the liquidity it has injected to generate inflation expectation. The fiscal channel would also be substantially weakened if the liquidity injected is to be withdrawn after the recession, as further tax increases would be expected offsetting the initial consumption and investment incentives given by the policy (Bernanke at al., 2004).
  21. If it is expected that short-term nominal interest rate would be set as the same manner as before after its escape from the zero bound, the long-term interest rate would be unaffected and the causal chain would therefore be broken (Dotsey, 2010).
  22. By this argument the QE programmes in the U.S. in recent years are likely to be ineffective. In a speech by the vice chairman of the Federal Reserve System Donald Kohn (2009), in an attempt to prevent future inflation, the QE programmes would be reversed when the adverse economic condition no longer prevails; and the market expects the Fed would reduce its balance sheet successfully after the recovery of the banking system (Dostey, 2010).
  23. Bernanke, B. S. (2009, April). Four Questions about the Financial Crisis. Speech presented at the Morehouse College, Atlanta, Georgia.
  24. Bernanke, B. S., Reinhart, V. R., & Sack, B. P. (2004). Monetary policy alternatives at the zero bound: an empirical assessment. Finance and Economics Discussion Series. Divisions of Research & Statistics and Monetary Affairs. Federal Reserve Board, Washington, D.C.         
  25. Dotsey, M. (2010). Monetary policy in a liquidity trap. Business Review, Q2 2010, pp. 9-15. Federal Reserve Bank of Philadelphia.
  26. Elmendorf, D. W. (2010, February 23). Policies for increasing economic growth and employment in the short term. Testimony before the Joint Economic Committee of the U.S. Congress. Retrieved from
  27. Karunatilleka, E. (1999). The Asian economic crisis. Research Paper 99/14. Economic Policy and Statistics Section, House of Commons Library.
  28. Kohn, D. L. (2009, April). Monetary Policy in the Financial Crisis. Speech presented at the Conference in Honor of Dewey Daane, Nashville, Tennessee.
  29. Mishkin, F. S. (2011). Monetary policy strategy: lessons from the crisis. NBER Working Paper Series, National Bureau of Economic Research.
  30. Tassey, G. (2011). Beyond the business cycle: the need for a technology-based growth strategy. NIST Economic Staff Paper, National Institute of Standards and Technology.