MONEY and BANKING PAPERS LOW GRAPHICS

 


Opposing Views
of the Effectiveness of Monetary Policy


by
Sachin Shah
 

 

Monetary policy is a powerful governmental weapon which has historically proven that it is difficult to wield.  This difficulty is one of the reasons why some economists doubt the effectiveness of monetary policy as a whole.  These economists find that monetary policy is difficult to implement because of estimation problems and time lag problems, as well as cyclic effects.  They also point out situations in which monetary policy may not work at all.  On the other hand, some economists swear by monetary policy as one of the most influential economic tools.  These economists show that controlling money supply in America is a relatively young idea, and is developing rapidly.  They also attempt to show that money supply affects many variables in our economy, and that it is useful in more situations than the anti-monetary policy economists, Keynesian economists, would have us believe.

To gauge the ineffectiveness of monetary policy some economists call our attention to the great depression.  How could governmental monetarists allow one quarter of the country to be unemployed[1] or for one third of commercial banks to be put out of business by “bank panics?”[2]  People who took part in these bank panics were not only taking out their “own” money, but were taking out possible loans for others (the amount they took out multiplied by the money multiplier) which eventually became 31% of the total money supply.[3]  The economist best fit to use monetary policy would be able to tell the future, or at least provide a pretty good estimate.  These estimates are very difficult when sometimes the results of policy actions are not seen for months to over a year.  Corrections of these actions could take just as long, sending the country for a roller coaster ride.  “Milton Friedman, lifelong foe of the Federal Reserve System”[4] blames the “Fed” for their inaction during the great depression.  Had the Fed raised the money supply during the depression perhaps more banks would be able to survive, unemployment would drop, and the U.S. would pull itself out of the depression much sooner and quicker than it had.  The failure to act was probably due to the immaturity of monetary policy at the time, and perhaps learning from the past is the best we can do.  There is still, however, the fact that it takes great estimation skills to use monetary policy effectively, and this provides doubt for the effectiveness of the Fed’s actions concerning money supply.  There is also a time lag associated with monetary policy.  The fed had raised the discount rate too late in order to slow down the stock market boom of 1929.  The ill timed raise of the discount rate did contract the money supply; however, it did so during the stock market crash, making the entire situation a whole lot worse.  This time lag in the policy’s effect helps to magnify the estimation problem.


[1] http://www.shambhala.org/business/goldocean/causdep.html

[2] Mishkin, F.S.

[3] http://www.korpios.org/resurgent/Fed.htm

[4] http://www.korpios.org/resurgent/Fed.htm

 

Besides the estimation and time lag problems associated with monetary policy, there a cyclic effect which takes place when changing the discount rate to change money supply.  By lowering the discount rate banks will borrow more from the fed and approve more loans, increasing the money supply.  The increase in money supply will in turn lower the market interest rate, decreasing the supply of loans.

Even if one could estimate properly, there was no time lag, and no detrimental cyclic effects take place, how powerful can monetary policy actually be?  John Maynard Keynes has suggested that monetary policy would be as effective as “[pushing] on a string” when the interest rate falls below 2%.[1]   A few years ago Japan was described to be in a liquidity trap.  “Increasing the monetary base is theoretically of little value for the economy in a liquidity trap.”[2]  A common thought on the way to escape from such a trap is to slowly ease out of it, while operating the economy at a zero or close to zero interest rate.  Monetary policy in this case has been rendered quite ineffective.


[1] Meltzer, A.H.

[2] Ueda, K.

 

There are also many economists who are loyal supporters of the fed’s monetary policy.  Supporters of monetary policy may even call upon the same example of the great depression as a reason why the Fed’s monetary policy is extremely powerful.  There is considerable thought that if the economists had used the young policy ideas and had increased the money supply, much of the unemployment and low incomes could have been averted.[1]  The use of open market operations had just been discovered ten years before the depression.  Before the use of open market operations monetary policy had simply consisted of adjusting the discount rate.  Compared to open market operations the discount rate has proven less effective, and more difficult to handle; however, historically even the discount rate has been used advantageously.  In 1919 and 1920 the inflation rate had been estimated at 14% per year.  By raising the discount rate roughly 2% the Fed lowered money supply and dropped the inflation rate to zero, fulfilling the Fed’s immediate goal.[2]  Over the past 80 years the Fed has been able to learn how to better use their monetary tools, and has proven how effective monetary policy can be.  “The stock market crash of 1987 was even larger than the Crash of '29”[3]  Apparently the Fed has learned ways to use monetary policy effectively enough to prevent these “chain reactions.”[4]


[1] http://www.arts.unimelb.edu.au/amu/ucr/student/1997/Yee/depression.htm

[2] Mishkin, F.S.

[3] http://www.korpios.org/resurgent/Fed.htm

[4] http://www.korpios.org/resurgent/Fed.htm

 

Supporters may also call upon the fact that money supply can affect many important variables.  Increasing the money supply (through purchasing securities, lowering the discount rate, or lowering the reserve ratio) can stimulate investment by lowering the market interest rate.  An increase in money supply will also lower unemployment, and increase the inflation rate.  When in times of high unemployment, monetarists in the Fed may increase the money supply in attempt to sacrifice inflation for jobs.

Some supporters even contest the liquidity trap idea.  Many agree that the usefulness of monetary policy would decline, or even be ineffective, at close to zero interest rates; however, some economists deny that Japan, or any country, has ever been in a liquidity trap.  “No country has ever been in a liquidity trap, and Japan is not in one now.  Statements to the contrary are based on faulty analysis.”[1]  So if a liquidity trap has never been experienced, it seemingly does not pose a huge threat to the economy and would not discount the effectiveness of monetary policy.


[1] Meltzer, A.H.

 

In my opinion, monetary policy is a very powerful tool and our ability to use it effectively has improved over time.  I feel that the fed now manipulates the money supply more easily than they ever have.  In conjunction with fiscal policy it allows for a strong control of the economy.  Learning from the past has been one of the most important ideas concerning monetary policy, and our country has seen many changes in money supply from which we can learn.  Money supply figures date back at least to 1913, and maybe even farther.[1]  I also believe that there is less time lag now that open market operations is predominately used to control money supply, as the effect is almost immediate.[2]  Also many laws allow the fed to take monetary policy actions without consulting any other part of the government, cutting down on this time lag.  I believe that events such as the great depression show us that money supply is a very important concept, and I think the subsequent increased use of monetary policy has proven this.  The money supply affects many variables which are extremely important to our economy.  Perhaps monetary policy has been a little late, detrimental, or ineffective in the past, but the optimistic view would lead us to support  the monetary policy for all the good it has done as well as for its immense potential for  helping to guide this country’s economy.


[1] Schwartz, A.J.

[2] Mishkin, F.S.

 

References

 

 

Mishkin, F.S.  The economics of Money, Banking, and Financial Markets.  Sixth Edition.  2003.

 

Schwartz, A.J.  Money Supply.  The Concise Encyclopedia of economics.  The Library of economics and Liberty.  Online: http://www.econlib.org/library/Enc/MoneySupply.html

 

Meltzer, A.H.  A Liquidity Trap?  Online: http://www.gsia.cmu.edu/afs/andrew/gsia/meltzer/a_liquidity_trap.pdf

 

Online: http://www.korpios.org/resurgent/Fed.htm  What Role did the Fed Play in Causing the Great Depression?

 

Ueda, K.  Speech at Japan Society of Monetary economics.  December, 2001.  Online: http://www.boj.or.jp/en/press/koen072.htm#0202

 

Online:  http://www.arts.unimelb.edu.au/amu/ucr/student/1997/Yee/depression.htm  The Cause of the Great Depression in 1929.

 

Online:  http://www.shambhala.org/business/goldocean/causdep.html  What Caused the Great Depression of the 1930’s?

 

 

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