Problems with Monetary Policy

• When a central bank cuts interest rates


  There is a risk of demand-pull inflation as a trade-off as a conflict of macro objectives
• Expansionary monetary policy is successful at lowering interest rates

  Aggregate demand shifts right
• Aggregate demand shifting right


  Can lead to higher growth and lower unemployment but also higher demand-pull inflation
• Lower interest rates stimulate aggregate demand


  Can widen a current account deficit
• Liquidity trap


  When interest rates are already so low, consumers and businesses have already converted their illiquid financial assets into more liquid assets like cash, so further interest rate cuts will not be effective
• Interest rates fall


  Rate of return on savings falls, potentially becoming negative if inflation is higher than the nominal interest rate
• Expansionary monetary policy comes with time lags, taking 18 months to 2 years to fully feed through into the economy
• Output gap


  The difference between actual output and potential output
• When the economy is close to full employment with a small negative output gap


  Interest rate cuts will mainly lead to higher inflation rather than growth and reduced unemployment
• When the economy is in deep recession with a large negative output gap


  Interest rate cuts have greater potential to boost growth and reduce unemployment without much demand-pull inflation
• Consumer confidence


  Consumers need to be confident in their job prospects and future income in order for lower interest rates to incentivise borrowing and spending
• Business confidence


  Businesses need to be confident in future demand and profitability in order for lower interest rates to incentivise borrowing and investment
• If consumer confidence and business confidence is low


  Lower interest rates may not promote more borrowing for consumption or investment
• If banks are unwilling to lend


  Interest rate cuts by the central bank will be ineffective
• If banks do not fully pass on interest rate cuts


  The boost to aggregate demand will be limited
• Larger interest rate cuts


  Are more desirable to significantly incentivise borrowing and boost aggregate demand
• If interest rate cuts are ineffective, the central bank may use alternative measures like quantitative easing