The effectiveness of monetary policy

Overview

Main weaknesses of monetary policy, liquidity trap and rise in interest rates affect borrowers and savers differently.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the strengths of monetary policy compared with other instruments of macroeconomic management?

   Model answer

   Decisions can be taken quickly and frequently by a small committee, without the need for legislation or a budget, so the instrument can respond to news within weeks rather than a year. It is easily reversible, so a change that turns out to be wrong can be undone without the political difficulty that attends reversing a tax change or cancelling a spending programme. Placed with an independent institution and directed at a published target, it carries credibility that helps anchor expectations, which does part of the work before any rate change is needed. It works across the whole economy without the government having to choose which industries or groups to favour. And it does not directly worsen the public finances, which matters when debt is already high.

2. 2

   What are the main weaknesses of monetary policy?

   Model answer

   It works with long and variable lags, so decisions must be based on forecasts and can take effect after conditions have changed. It is a blunt instrument: one interest rate applies to the whole economy, so it cannot be directed at a particular region, sector or group, and it will restrain a booming region and a depressed one equally. It cannot be cut far below zero, so it runs out exactly when a deep recession makes it most necessary. Its transmission depends on a willing banking system and confident borrowers, both of which are absent when they are most needed. It is poorly suited to inflation caused by supply shocks, since it can only reduce inflation by reducing demand and output. And it has substantial distributional side effects, transferring income between borrowers and savers and raising the value of assets held by the already wealthy.

3. 3

   What is a liquidity trap, and why does it disable conventional monetary policy?

   Model answer

   A liquidity trap is a situation in which interest rates are so low that further reductions do not stimulate spending, because households and firms are willing to hold any additional money rather than spend it or lend it out. It arises when confidence is very weak and expected returns on investment are negative or highly uncertain, and when the private sector is trying to repay debt rather than take on more, so the demand for credit does not respond to its price. In such conditions the central bank can supply reserves without limit and see no increase in lending or spending, and because the nominal rate cannot fall far below zero it cannot deliver the negative real rate that might be required. The usual conclusion is that fiscal policy, which raises spending directly rather than relying on someone choosing to borrow, is the more effective instrument in a trap.

4. 4

   How does a rise in interest rates affect borrowers and savers differently?

   Model answer

   Borrowers with variable-rate debt face higher payments immediately, so their disposable income after debt service falls and they cut spending; borrowers on fixed rates are unaffected until they refinance, at which point the increase arrives all at once. Savers holding deposits receive more interest, so their income rises, though banks typically pass rate rises to savers more slowly and less completely than to borrowers. The two groups differ systematically: borrowers tend to be younger, on lower net wealth and spending most of their income, while savers tend to be older and wealthier and to save a larger share of any gain. A rise therefore transfers income from high spenders to low spenders, which is exactly why it reduces aggregate demand, and it has a distributional effect between generations as well as a macroeconomic one.

5. 5

   How do sustained low interest rates affect pensioners and people saving for retirement?

   Model answer

   Those living on the interest from savings receive less income, and if inflation exceeds the rate they receive, the real value of their capital falls as well. Those buying an annuity at retirement are worse affected: an annuity's rate depends on the yield available on long-dated bonds, so when yields are pushed down a given pension pot buys a permanently lower income for the rest of the person's life. Pension schemes that promise a defined income face the same arithmetic, since the present value of their future obligations rises when the discount rate falls, so deficits appear and sponsoring employers must divert funds into them rather than into investment. Against this, pensioners who own property or shares gain from the higher asset prices that low rates produce, so the effect within the group is uneven.

6. 6

   How does a change in interest rates affect firms?

   Model answer

   It changes the cost of financing investment, so a rise makes some projects unprofitable at the margin and reduces capital spending, particularly for long-lived projects whose returns are far in the future and therefore heavily discounted. It changes the cost of servicing existing debt and of financing stock and working capital, which affects cash flow and, for highly geared firms, survival. It changes demand for the firm's output, since its customers face the same rates, and for firms selling consumer durables and housing-related goods this effect is often larger than the effect on their own borrowing costs. And it moves the exchange rate, which affects exporters' competitiveness and the cost of imported components. Firms differ greatly in their exposure: a highly geared exporter selling durables is affected several times over, while a low-debt firm selling necessities domestically may barely notice.

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