Monetary policy is a means to influence the economy through changes in the money supply. Changes in the money supply affect aggregate demand. As far as economic capacity is available, changes in aggregate demand will affect short-run aggregate supply (actual real GDP).
Supply side shocks case
However, monetary policy is not always effective in influencing economic activity when the source of economic problems comes from the supply side. For example, when supply falls due to rising oil prices, production activities contract because production costs rise sharply.
Also, the rising oil price increases energy and transportation costs, which are vital for many industries. The final impact, inflation is pushed up.
When the central bank responds by lowering interest rates, it will only produce further upward pressure on inflation. Stagflation – a period in which economic growth weakens but inflation is high – occurs.
The central bank does not direct how economic agents should act and respond
The next drawback is that the monetary transmission mechanism might operate not smoothly as in theory. Central banks do not always have tight control over the money supply.
When interest rates are cut, households might not necessarily respond by increasing loans and spending. Gloomy economic prospects may encourage them to save more and secure wealth, for example by buying gold, rather than for consumption on goods and services.
Likewise, even if interest rates fall, banks also don’t necessarily want to make loans. Again, gloomy economic prospects forces them to be extra careful in lending. They assume an increase in loans will only worsen their balance sheet due to high default rates.
When interest rates reach zero
When interest rates have been very low, monetary policy is in question. Cutting interest rates close to 0% might not reduce the level of savings and stimulate consumption. It also cannot eliminate deflation. This phenomenon is known as the liquidity trap. Japan and Europe experienced it and still faces it, at least until 2019. Then, in the United States, it also happened from December 2008 to December 2015.
To get out of the liquidity trap, the central bank adopted a non-conventional policy through quantitative easing (QE). Basically, QE is an open market operation, but it is carried out on a massive scale. Indeed, through a series of QE rounds, it is effective in the United States, but that might not necessarily appropriate in other countries.
QE also has risks. The central bank bought massive government securities. That way, money is pumped into the economy and the central bank collects a large number of securities on its balance sheet. When the central bank accumulates too many low-quality securities, economic agents can eventually lose confidence in the central bank and fiat money.
