Limitations of Monetary Policy

Monetary policy is used in the stabilization of prices and inflation control. However, monetary policy has quite a number of shortcomings and, as such, usually does not reach expectations. These shortcomings are discussed below.

1. Case of Deflation

Compared to inflation, deflation is usually hard to control. During deflationary periods, central banks reduce their policy rates to as low as zero. The economy, therefore, cannot be stimulated beyond this point. We’ve recently seen cases in which central banks have even opted for negative rates.

2. Case of Banks Decreasing the Money They Lend

Sometimes when the money supply rises, banks can have excess reserves, making the short-term rates decrease. This is mostly a result of the business environment.

3. Uncertainty About How the Economy Reacts to Expansionary and Contractionary Policy

Uncertainty about the effect of a policy puts the economy and prices on a complicated path. Some economies might over or underreact to central bank policies. It is imperative to note that economists often disagree on the policies central banks should use.

Every attempt of central banks to manipulate the supply of money within an economy does not always work. This is due to their lack of capacity to control the deposits households and corporations make in commercial banks.

4. Liquidity Trap

A liquidity trap is when interest rates are close to zero and savings rates are high, rendering monetary policy ineffective. In a liquidity trap, consumers choose to avoid purchasing treasury securities and keep their funds in savings because of the prevailing belief that interest rates will soon rise. A rise in interest rates will cause a decrement in bond prices.

5. Case of the Government Reducing the Money Supply

If a government decreases the money supply, for example, with higher taxes, individuals would expect low future inflation. This could render an expansionary monetary policy ineffective.

6. Bond Market Vigilantes

Vigilantes are individuals who participate in the bond market, which can reduce their demand for long-term bonds, thus raising their yields. The rise in yields can easily make it difficult for any expansionary monetary policy to be effective.

Question

Which of the following is least likely a limitation of a monetary policy?

A. Liquidity trap

B. Stabilization of prices

C. Bond market vigilantes

Solution

The correct answer is B.

Stabilization of prices and inflation control are functions of monetary policy.

Option A and C are incorrect. Liquidity trap and bond market vigilantes are limitations of monetary policy.

Reading 16 LOS 16n:

describe limitations of monetary policy