Is monetary policy alone enough to stimulate economic recovery?

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Natalie Ho's picture

In an economic crisis, governments have few monetary policy instruments to use and they tend to remain the same even if the national economy has been affected by a sector specific shock or an asymmetric shock. Being able to adjust the policy rate is vital for any nation. To emphasise how important this tool is for any government or central bank when attempting to stimulate its economy in the face of an economic crisis, the current European Sovereign Debt Crisis will be used as an example as its members‟ loss of independent monetary policy has led to disharmony in the common currency area.

There are four types of monetary policy frameworks; exchange rate, precious metal, monetary targeting and inflation targeting. The Euro area operates a combination of monetary targeting and inflation targeting for their monetary policy framework. This is because the ECB is largely based upon the structure and framework of Bundesbank, (Dyson, 2000, p.3). Governments and independent central banks control money and monetary targets so that they can try to influence the inflation rate and typically, monetary targets are used to control the purchasing power of money. Usually, if a government or independent central bank believes that money demand will surge, then they will loosen monetary targets; if they believe that money demand will fall, then they will tighten monetary targets. There are problems with monetary targets being used as a monetary policy framework. Demand for money is not always constant as it is unpredictable. Keynesian theory suggests that a sudden increase or decrease in money demand would have an impact on interest rate (The Economist, 2010). Keynes argued in his theory that if there was unbalanced trade between countries who were participating countries of a monetary system, the countries with trade deficits would be obliged to adjust their economies in order to reduce demand for imports by increasing interest rates and to regain the lost competitiveness of their exports by making cutbacks in wages.

De Grauwe (2003) states that, interest rates are cut when inflation is low or when aggregate demand in the economy is not at the level it is capable of producing. They are raised when there is overheating of the economy along with the inflation rate in order to „cool‟ the economy as they reduce three factors; real household incomes, firms‟ competitiveness and the overall investment incentives. A country‟s rate of inflation affects its competitiveness because if the domestic prices of exports are increasing at a faster rate than other members of the monetary union, then their domestic exports to elsewhere in the monetary union and the rest of the world will be more expensive compared to foreign imports. The inflation rate of a nation tends to become lower and steadier after an inflationary targeting system is introduced. This is not the case with the Euro-zone as there are seventeen nations, not just an individual, and they are all trying to fit their different sizes and types of economies to one inflation rate, a view also supported by Soros (2010).

Friedman (1969) argues in his works that the optimal interest rate is zero but no central bank in Europe or the rest of the world agree with his point of view and they are supported by Woodford (2003). His theory suggests that differences between the actual rate and the optimal rate of inflation in an economy will cause the government to adjust their monetary policy i.e. interest rates accordingly. If the actual rate of inflation is bigger than the optimal rate of inflation, the central government will need to tighten its monetary policy i.e. increase its policy rates. If it is vice-versa, then the central government will have to relax its monetary policy i.e. reduce its policy rates. If Friedman‟s policy is used by a government, it would mean that their monetary policy is inflation targeting. Money holders would not experience a loss of value in the currency, token money of government bonds that they hold as there is no change the rate of inflation. Friedman‟s policy could work in an ideal world but in reality, governments would not be able to apply it without using other policies to maintain an ideal rate of inflation. The ECB cannot use this theory to control inflation in the EMU currently because they need a policy which can help warm up most of the economies as there are low economic growth rates across the monetary union. Sinclair (2003) argues that if the rate of inflation was held at zero, they would not be able to use expansionary monetary policy to improve the conditions of the economy and instead, they would have to try to build up a „cushion‟ rate of interest for long term investments such as government bonds as they can depreciate in value or appreciate at a lower rate if their interest rate is zero.

It is highly unlikely that the Euro area countries will unanimously agree to devalue the common currency and therefore the exchange rate cannot be used to increase competitiveness and trade; and members of the Euro-zone will have to synchronise their different rates of inflation instead. However, Issing (2001) states that this can create pressures on the balance of payment accounts of the member states, especially those with high inflation rates as it can increase trade deficits and slow the economic growth rate. The rate of inflation can be affected indirectly by other macroeconomic and microeconomic policies, thus fiscal policy has to be coordinated such as taxation levels and government expenditure. As fiscal policy is determined separately by national governments within the Euro area, it could be a factor which has increased the rates of inflation in the peripheral countries as they have failed to maintain fiscal discipline. However, even if there was a common fiscal policy for the Euro area, it would not be viable as there is a varied range of taxation levels between the Euro area member states. Martin (2004) suggests that, due to different social policy in each country concerning employment such as minimum wage levels, maximum hours of work as well as welfare and benefits; a supranational tax policy would not be possible unless other public social policy areas which could be affected by it are brought under the control of the European Parliament and other EU institutions as well yet this is politically unfeasible as the degree of a political union within the Euro area is not large enough to implement this and is supported by Taylor (2000) and Tondl (2000). It is also hard to envisage, as no Euro-zone member is willing to forfeit such a large amount of power and sovereignty.

The current common monetary policy of the EMU, to a certain extent, is ineffective. This is due to the diverse range and sizes of the seventeen economies and each one needs a different solution to prosper again. Portugal and Greece have traditionally been uncompetitive whereas Ireland and Belgium have small economies which are largely dominated by oversized banking sectors. For the Southern European countries i.e. Spain, Portugal, Greece and Italy; competitiveness has to increase in order for them to benefit from the single currency. They must reduce their dependency on foreign capital inflows because if investors sense a potential crisis, they tend to cease providing capital and in most cases, they will never return to invest again. They can rebuild their economy by introducing economic reforms to increase productivity levels and reduce labour costs in order to increase revenue. However, the adjustment time period can be extensive and failure to reform their economies will prolong their recession. Ireland and Belgium will have to reduce its economy‟s dependency on the national banks as it creates volatility in the markets. Their solution would be to enforce tighter control in the financial sectors and to expand other sectors of their economies.

To conclude, monetary policy alone is not effective enough to stimulate economic recovery as an adjustment in the policy rate is not the only influencing factor on the rate of inflation as it is affected by other economic policies. Open and frank dialogue between governmental and non-governmental bodies is also needed to remove any conflicts of interest. Financial crises are caused by the profligacy and negligent of national governments as ultimately, they are responsible for maintaining regulated industries in their economy in order to eliminate risk of a crisis arising. Therefore, the monetary policy instruments to be used in any case are very similar as financial crises are usually caused by reckless banks and have invariable consequences. Thus, they can be resolved in a near identical manner.



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