Limitations of Monetary Policy

The limitations of monetary policy include problems in the transmission mechanism and the relative ineffectiveness of interest rate adjustment as a policy tool in deflationary environments.

Problems in the Monetary Transmission Mechanism

There may be some occasions when the will of the monetary authority is not transmitted seamlessly through the economy.

The more credible the monetary authority, the more stable the long end of the yield curve, the monetary authority will be more confident that its “policy message” will be transmitted throughout the economy. (the bond market vigilantes)

The demand for money becomes infinitely elastic, so that further injections of money into the economy will not serve to further lower interest rates or affect real activity. This is known as a liquidity trap.

Deflation is a pervasive and persistent fall in a general price index and is more difficult for conventional monetary policy to deal with than inflation.

This is because cutting nominal interest rates much below zero to stimulate the economy is difficult. It is at this point that the economic conditions for a liquidity trap arise.

A deflationary “trap” is characterized by weak consumptiongrowth, falling prices, and increases in real debt levels.

Quantitative easing (QE), is operationally similar to open market purchase operations but conducted on a much larger scale.

The additional reserves created by central banks in a policy of quantitative easing can be used to buy any assets (risky when purchase assets with credit risk).

The ultimate problem of monetary policy is that they cannot control the amount of money that households and corporations put in banks on deposit, nor can they easily control the willingness of banks to create money by expanding credit.