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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 is balance of payment
Tih Reply
I don't know
balance of payment is the sum total of a country receipt for her exports and the total payments made for her imports.
discuss collusion of An oligopoly
Fikile Reply
ɧơɯ Ćąŋ ɖɛmąŋɖ Ćɧąŋɠɛ ŧơ want
henry Reply
what is money
Ngea Reply
money is everything
a regulatory object between producer and consumer of monetary system
money is anything generally accepted for the payment of goods and services and for the settlement of debt
a regulatory object of good and services between producer and consumer ( all these comes under monetary system)
what is price surveillance?
Berry Reply
what is favourable balance of trade
what is demand
Oluchi Reply
what are two classical macroeconomics and what're their theories say about their equations?
what is the formula for calculating elasticity
aza Reply
what is elasticity of demand?
Rita Reply
flexibility of demand in terms of price , income and tax ratio .
Causes of economic growth
pierre Reply
What is elasticity of demand
What are the causes of economic growth
economic growth, establishment of industry, encourage of investor's, farm productivities, creation of institutions, construction of good road etc
elasticity of demand can be said to be the responsiveness of demand to a change in prices
impact of collusion in the economy referring to inefficiencies illustrated by means of graph
nondumiso Reply
The Factor price will determine the choice of techniques to produce.Expantiate
what is elasticity of demand?
Etta Reply
state and explain two types of demand
Institution involved in money market
Gande Reply
what is Economics
Kwame Reply
Economic is the study of scarcity
Economics is the study of a lot of things. It is split up into two areas of study, Microeconomics and Macroeconomics. Microeconomics is the study of an individual's choices in the economy and Macroeconomics is the study of the economy as a whole.
Economics is a science that studies human scarcity
What is Equilibrium price?
Equilibrium is the market clearing price. The point at which quantity demanded equals quantity supplied. The point at which the supply and demand curves intersect.
Equilibrium price*
Refers to the study of how producers use limited resources to satisfy human unlimited wants
why is economics important
Derrick Reply
why economics important
name four ways to encourage the development of trade amongs country

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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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