MONETARY POLICY: Is Expansionary Monetary Policy Effective during an Economic Slowdown?

Is an Expansionary Monetary Policy Effective During a Downturn in the Economic Cycle?

As I’m sure many of you know, monetary policy involves the central bank and the government who make decisions on interest rates, the money supply and also the exchange rate. When referring to an expansionary monetary policy we mean reducing the interest rate, increasing the money supply and incorporating measures to cause a fall in a country’s exchange rate.

This policy should work to raise the level of output in a country – its GDP. It should also work to raise demand levels throughout the economy (AD).

Reducing the Central Bank’s official interest rate will, in theory, lead to market rates being reduced. This will affect both domestic and external demand. This is because a lower interest rate reduces the incentive to save and so in turn leads to greater levels of consumption and investment from consumers and firms. Furthermore, a lower interest rate reduces the cost of borrowing, raises the demand for exports and lowers the demand for imports because it leads to a fall in the exchange rate. The overall effect of this policy measure is an increase in aggregate demand which during a downturn in the economic cycle, cushions its negative impact.

However, it must be noted that reducing the base rate may not lead to reductions in market rates and therefore expansionary monetary policy may not be effective. Take LIBOR as an example. Granted it is a special case, where in 2008 the banking system crisis made banks wary of lending to each other without a significant risk premium.

On the contrary, this policy measure CAN be extremely effective as it possesses the ability to give a rapid response to the downturn due to the distinct absence of time lags in monetary policy decisions.

There are weaknesses though in the monetary policy transmission mechanism. Reductions in the rate of interest may not stimulate spending and investment during times of an economic downturn as the interest elasticity of demand for loans tends to be inelastic. Firms are unlikely to increase investment because borrowed funds are cheaper. They are likely to delay investment if they expect the downturn to carry on.

Similarly, consumers are unlikely to borrow money to fund raised levels of consumption if they are unemployed or at least fear they may soon be – which is extremely pertinent in times of economic downturn. During this time therefore, expectations may be a more important determinant of demand than the rate of interest.

Moreover, the impact of lower interest rates on net external demand depends on the price elasticities of demand for the exports and imports. It also depends on the extent to which the exchange rate changes after the base rate has been lowered. Typically, in a global slowdown, foreign income becomes a more important determinant of the demand for exports than the actual price of the exports.

 

Cutting the interest rate may not be as effective as initially had been hoped because, using the Bank of England in 2008 as an example, they had to supplement this policy via quantitative easing. As well there is likely to be a time lag between when the policy is put in place and when the economy sees its results.

One might say that fiscal policy may be more effective at boosting levels of demand i.e. taxation and government spending decisions.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.