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By the end of this section, you will be able to:

  • Analyze whether monetary policy decisions should be made more democratically
  • Calculate the velocity of money
  • Evaluate the central bank’s influence on inflation, unemployment, asset bubbles, and leverage cycles
  • Calculate the effects of monetary stimulus

In the real world, effective monetary policy faces a number of significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: the central bank    must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars. Then it takes time for these changes to filter through the rest of the economy.

As a result of this chain of events, monetary policy has little effect in the immediate future; instead, its primary effects are felt perhaps one to three years in the future. The reality of long and variable time lags does not mean that a central bank should refuse to make decisions. It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.

Excess reserves

Banks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves    above the legally mandated limit. For example, during a recession banks may be hesitant to lend, because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans.

When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well. This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply. If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans. Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession    , because they recognize that firms’ sales and employees’ jobs are more insecure in a recession, and they do not want to face the need to make interest payments. The result is that during an especially deep recession, an expansionary monetary policy may have little effect on either the price level or the real GDP    .

Japan experienced this situation in the 1990s and early 2000s. Japan’s economy entered a period of very slow growth, dipping in and out of recession, in the early 1990s. By February 1999, the Bank of Japan had lowered the equivalent of its federal funds rate to 0%. It kept it there most of the time through 2003. Moreover, in the two years from March 2001 to March 2003, the Bank of Japan also expanded the money supply of the country by about 50%—an enormous increase. Even this highly expansionary monetary policy, however, had no substantial effect on stimulating aggregate demand. Japan’s economy continued to experience extremely slow growth into the mid-2000s.

Questions & Answers

what's economic
John Reply
what is the meaning of imperfect market structure
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what is market economy
Jusu Reply
what's demand in economics?
Abi Reply
Demand in economic is the good a consumer is willing or able to purchase at a particular time
explanation of graph,bar chart,pie chart with examples
4. Assume, after completing your economics class, you explain your friend that about 65% of GDP is spending on consumption. Your friend tells you that people are greedy and it is better for GDP if they spend on services or experiences. What would be your answer to your friend?
Javohir Reply
What is power
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how can I choose a model for analyzing primary data?
Dipsikha Reply
economics is science because it used sciencetific ways in solving it problem
Is economics a science, more expanciate
Saliman Reply
yh because it adopts scientific methods in research and analysis of economic issues
Analyse Eskom in terms of the characteristics of a monopoly
Brilliant Reply
microeconomics deals with individuals and firms while macroeconomics deal with the activities of the society in large
C-Stixxs Reply
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what is your question
what definition did Adams Smith gave about economic
why Economics is science
Fixed Reply
what is economic
Arome Reply
is a science which studies human behavior as a relationship with ends n scarce which have alternative uses
Explain four reason why scale of preference is necessery
Afusat Reply
What's a perfectly elastic demand
jessica Reply
what is the perfect elasticity of demand
what is a balance budget
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balance budget is when the expenses ND tax re equal
it is when expenditure and revenue are equal

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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