Is monetary policy alone enough to stimulate economic recovery?

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Samuel Kenney's picture

Monetary policy for the last 80 years has been widely accepted as a viable means of mitigating the effects of an economic recession. However, unprecedented global and national economic crises have pushed the limits of traditional monetary policy, casting doubt on its effectiveness to stimulate an economic recovery. The United States Federal Reserve has aggressively pursued monetary policy to alleviate their economic woes only to find themselves still struggling with an anaemic economy and high unemployment four years later. This essay gives a brief summary of traditional expansionary monetary policy and other tools that can be used to combat a recession; discusses the challenges facing current U.S. monetary policy and the significance of the United Kingdom’s austerity measures, with regards to the effectiveness of monetary policy; and concludes that monetary policy is not sufficient to stimulate a recessed economy.

During an economic recession the central bank uses expansionary monetary policy to stimulate an economic recovery. Expansionary policy is when the central bank attempts to lower the federal funds rate and expand the money supply. They achieve this by using the three main tools at their disposal. The primary tool is expansionary open market operations. These are the purchasing of government backed securities in the open market to expand the money supply. The second tool is the lowering of the reserve requirement. A lower reserve requirement signifies that banks do not have to hold as much physical cash and thus can lend a higher percentage of their reserves increasing the money supply. The third tool is the ability of a central bank to lower the discount rate. A lower discount rate allows banks to borrow more money at a lower price. This once again provides them with more opportunities to inject money into the economy.

Monetary policy is successful when the federal funds rate decreases and the money supply increase causing debt and goods become cheaper in the short run. This entices investors and consumers to borrow and spend, shifting the aggregate demand curve outward and increasing real economic activity.

In concordance with expansionary monetary policy, governments of recessed economies can also enact expansionary fiscal policy. This means increasing government expenditures or reducing taxes. Both methods are aimed at stimulating the economy in the short run and paying off the incurred debts in the long run. In addition, when traditional monetary policy fails to produce the desired stimulus for a recessed economy and the interest rate is approaching zero, traditional monetary policy has at that point failed, and the only tool left to the central bank is quantitative easing. Quantitative easing is another way for the central bank to inject cash into the economy to lower interest rates and expand the money supply by the purchasing of other financial assets. Quantitative easing, accompanied by credible announcements from a central bank regarding future policy decisions should raise expected inflation and increase the expected consumer price index ultimately causing lending and spending to once again become more attractive in the short run.

In many past cases monetary policy has proven effective at mitigating the effects of a recession. However, it is not without flaws, as is evidenced by the excruciatingly slow recovery from the “Great Recession” in the United States over the last four years. The United States Federal Reserve has committed itself to stimulating the economy by using all of the tools at their disposal including several rounds of quantitative easing. They have expanded their reserve balances to unprecedented levels, approximately 1.7 trillion dollars (FRED). In addition the Federal Open Market Committee (FOMC) recently released a statement saying that they will keep the federal funds rate between 0 and 0.25 percent until the end of 2014, reaffirming their commitment to future expansionary monetary policy (The Federal Reserve).

So with the aggressive expansionary monetary policy why is the United States economy still stagnant? The money supply is gargantuan, the interest rates sit very near zero, and yet the U.S. economy remains languid. The answer lies in the fact that the U.S. economy is caught in a liquidity trap. A liquidity trap is when short term interest rates approach the zero bound and the money flowing into the economy from monetary policy is held by households and banks and has no effect on output or prices (Dotsey). Monetary policy appears to be totally ineffective at this point. However, recent literature suggests this is not the case. In “The Zero Bound on Interest Rates and Optimal Monetary Policy,” Eggertson says that in the long run demand is dependent on the future paths of interest rates and inflation. This signifies that if the central bank can affect future expectations where the zero bound is not a factor, monetary policy becomes relevant again. But, and it’s a big but, the central bank has to convince the economy that they are indeed going to allow prices to climb even after deflationary pressures abate. The normal response to the release of deflationary pressures is contractionary monetary policy, and households understand this. The central bank has to have enough credibility to convince the economy that they are indeed going to stay the new course (Eggertson). The success of the monetary policy counts on it, hence the recent FOMC report regarding extended plans to keep the federal funds rate low.

However, even if the recent announcement finally stimulates economic growth, a liquidity trap is still an enormous liability for the success of monetary policy as shown by the last four years of anaemic growth in the U.S. As previously stated, when caught in a liquidity trap monetary policy depends on correct manoeuvres by the central bank and the population reacting to them rationally. This is not a strong formula for success especially when during a recession people are already wary of policy makers. In other words, escaping a liquidity trap is a perilous process.

Another important factor in determining the effectiveness of monetary policy is recognizing the contrast of current European policies, specifically those of the United Kingdom, and U.S. policies. The Bank of England began to combat the recession in the end of 2008 and start of 2009 using traditional monetary policy. Over the course of seven months they cut the bank rate from 5 percent to 0.5 percent and began increasing the money supply through the purchase of government securities. Since then, they have kept rates low and slowly and steadily increased their purchases of government securities in an attempt to keep the recession at bay (Bank of England).

However, the U.K.’s stimulus attempts to jumpstart the economy during the recession stop there. The United Kingdom and their Prime Minister, David Cameron, have made it exceedingly clear that the largest economic threat to them is massive government debt and that before additional stimulus is to be implemented to fight the recession, austerity measures must be implemented to reduce the debt (Cameron). As previously noted, expansionary monetary and fiscal policy both increase national debt, therefore the U.K. has opted against more aggressive monetary or fiscal stimulus, in favor of rigid fiscal austerity measures. The theory behind this is that government austerity will boost the confidence of the private sector; therefore any reduction in government spending is offset by an increase in private sector spending, all the while reducing government debt. In his recent keynote speech at the World Economic Forum in Davos, Prime Minister Cameron staunchly defended the British austerity measures and claimed the British economy is on the right track (Cameron).

Many U.S. economists vehemently oppose the austerity measures of the U.K., claiming they will increase the severity of the recession. However, regardless of who is right or wrong in this debate, British austerity illuminates a meaningful concept. Aggressive monetary policy coupled with accommodative fiscal policy, is not the answer for every economy. U.K. and U.S. policy differences signify the complexity of solving National economic problems. These are two highly developed countries competing for global economic prowess and they are taking nearly opposite approaches to similar problems demonstrating in no uncertain terms that other methods exist to repair a damaged economy.

Economies are idiosyncratic entities governed by humans that are bounded by their own rationality. Therefore, there is not and never will be one policy able to stimulate a real world economy with all its variability and unpredictability. Monetary policy remains an indispensable tool to assist in mitigating the effects of a recession but it is not sufficient to fully stimulate a severely recessed economy. The U.S. has engaged in aggressive monetary policy and they have exhausted all politically viable options to stimulate the economy and still unemployment levels remain painfully high and growth continues at a snail’s pace. Monetary policy is a powerful tool but it is not the answer.

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