Is monetary policy alone enough to stimulate economic recovery?

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Rita Palmeira's picture

Economies are characterized by cycles – either they are growing or under a recession. But in order to minimize the impact of such fluctuations, institutions have developed a set of tools. For example, governments use fiscal policy either to stimulate economic recovery or to slow down an economic expansion. This can be done through changes in public spending and in tax rates: an expansionary policy is expected to boost the economy, while a contractionary policy is supposed to slow down the economy. On the other hand, central banks and other monetary authorities can use monetary policy to attain the same objectives.

The main issue is whether one type of policy alone is able to reverse the economic trend. In this specific case, I will discuss whether monetary policy alone is enough to stimulate economic recovery.

Monetary policy aims at promoting economic growth and price stability, by controlling the supply and the growth rate of money in an economy. The main instrument available to do so is the interest rate, although reserve requirements and government securities can also be used. By changing the level of interest rate in an economy, monetary authorities seek to attain stable inflation, economic growth and a low level of unemployment. However, such goals are not always compatible and priorities usually diverge across institutions. For example, the Federal Reserve in the United States is known to pursue a policy aimed at economic expansion. That is, the target for the level of interest rate is usually low, in order to stimulate credit and thus allow for growth. On the other hand, the European Central Bank is much more conservative in which regards inflation. For this institution, price stabilization has a higher priority comparing to economic growth. Thus, interest rates are usually maintained high, so credit slows down and prices do not increase.

But how exactly does this mechanism work? How can the level of interest rate ultimately determine the level of economic growth and inflation? Essentially, the monetary authorities set the interest rate target through open market operations. That is, they sell and purchase bonds in order to decrease or increase the supply of money in the economy, respectively. For example, during a recession, the central bank’s aim might be to stimulate the economy. This can be done by decreasing the interest rates, as it will encourage credit and boost both production and consumption. As interest rates are the price of money itself, in order to decrease them the central bank must increase the quantity of money available in the economy. Through the already referred open market operations, the monetary authority will buy bonds, increasing the supply of money and decreasing the interest rates until the desired level. In other words, the central bank buys bonds, money enters in circulation, interest rates go down, credit is easier to obtain and the economy expands.

However, there are some drawbacks and no guarantee that the monetary policy alone will be able to stimulate economic recovery. One of the shortcomings is the conflict with inflation. That is, if the expansionary monetary policy is set for too long, the excess of money supply in the economy will lead to a generalize increase in prices. But as already referred, guaranteeing a stable level of inflation is also a goal of monetary authorities.

The clash between economic expansion and prices stabilization is particularly relevant for the European Central Bank actions, during the current financial crisis. The main issue is that the monetary policy is common to a set of heterogeneous countries, which were affected in completely different ways by the financial crisis. Thus, within the European Union, some countries would prefer the focus of the European Central Bank to be on low inflation, while others would prefer it to be on economic growth, through low interest rates. In this specific case, monetary policy alone is not enough to stimulate economic recovery, as it has been observed. While some countries, such as Germany, pressure the European Central Banks to maintain high interest rates, there are other countries which suffer from those measures, namely the ones with high debt ratios. Consequently, there are some countries, such as Greece, that would prefer the interest rates to be lowered, in order for them not to have to pay such high interest payments on national debt. Thus, the sovereign debt can be seen as another reason why monetary policy by itself is not able to stimulate the recovery of such different countries at the same time. In this specific case of a monetary union, there appears to be only two solutions: either it comes to an end or they evolve into a federal union. One single fiscal policy combined with one single monetary policy could be the solution to stimulate economic recovery in a much more efficient way.

In my opinion, another conclusion can be taken from what was referred above. It seems that the more open is one economy, the more difficult it is to monetary policy alone to be enough to stimulate recovery. That is, it is harder to choose the correct monetary policy to apply to a set of heterogeneous countries, than to a single country.

Thus, the higher the degree of openness of an economy, the more complex will have to be the mix of policies necessary to sustain economic growth and to fight recessions and financial crisis. As a result, no single recipe can be given, as the effectiveness of monetary policy will depend not only on the country itself but also on the nature of the financial crisis.


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