Instead of understanding that low interest rates are the long-run effect of previous tight-money policies, they incorrectly see the low rates as a failed attempt at monetary stimulus.
Observers also question the effectiveness of monetary policy when interest rates fall to zero. If nominal interest rates are zero or slightly negative, investors tend to hold currency, a safe asset with a nominal rate of return of zero.
This puts a floor on interest rates, prompting some pundits to infer that when interest rates are already quite low, they cannot be further reduced enough to significantly boost the economy. For instance, in Singapore the central bank uses exchange rates rather than interest rates as its policy tool. When the Singapore central bank wishes to stimulate the economy, it depreciates the Singapore dollar in foreign exchange markets. Admittedly, it is unlikely that the Fed would use exchange rates as a policy instrument.
But the central bank still has many other policy tools that can boost spending, even when interest rates are near zero. Think of it this way: if a motorist intends to drive 50 mph but is slowed by heavy traffic to 30 mph for an hour, the driver would have to spend the next hour at 70 mph, or two hours at 60 mph, to make up for the slowdown. Thus, if the policy goal were 2 percent annual inflation in the long run, then a year of 0 percent inflation such as in , would lead the central bank to raise its inflation target above 2 percent over the next few years.
It might aim for 2. In other words, the price level would be targeted starting from year-zero prices at percent: percent in year one, percent in year two, percent in year three, and so on.
Actually, the targets would be slightly higher, owing to the compounding effects of percentage changes. In my view, an even more effective policy than inflation level targeting would be to stabilize the growth of nominal gross domestic product NGDP —which is made up of economic growth plus inflation—perhaps along a 4 percent annual growth trend line.
Expectations of higher inflation and faster real GDP growth would tend to boost the demand for credit, which would raise equilibrium interest rates above the lower bound of zero. Central banks in Europe and Japan have also experimented with slightly negative interest rates as a way of discouraging banks from hoarding reserves. No funding was received for conducting this study. The views expressed here are solely those of the authors and do not represent the views of any other person or institution, nor do they necessarily reflect the views of the National Bureau for Economic Research.
Download Citation Data. Share Twitter LinkedIn Email. Pros Interest Rate Targeting Controls Inflation A small amount of inflation is healthy for a growing economy as it encourages investment in the future and allows workers to expect higher wages. Central Banks Are Independent and Politically Neutral Even if monetary policy action is unpopular, it can be undertaken before or during elections without the fear of political repercussions.
Weakening the Currency Can Boost Exports Increasing the money supply or lowering interest rates tends to devalue the local currency. Cons Effects Have a Time Lag Even if implemented quickly, the macro effects of monetary policy generally occur after some time has passed.
Monetary Tools Are General and Affect an Entire Country Monetary policy tools such as interest rate levels have an economy-wide impact and do not account for the fact some areas in the country might not need the stimulus , while states with high unemployment might need the stimulus more.
The Risk of Hyperinflation When interest rates are set too low, over-borrowing at artificially cheap rates can occur.
Pros Can Direct Spending To Specific Purposes Unlike monetary policy tools, which are general in nature, a government can direct spending toward specific projects, sectors or regions to stimulate the economy where it is perceived to be needed to most. Can Use Taxation to Discourage Negative Externalities Taxing polluters or those that overuse limited resources can help remove the negative effects they cause while generating government revenue.
Short Time Lag The effects of fiscal policy tools can be seen much quicker than the effects of monetary tools. Cons May Be Politically Motivated Raising taxes can be unpopular and politically dangerous to implement.
Tax Incentives May Be Spent on Imports The effect of fiscal stimulus is muted when the money put into the economy through tax savings or government spending is spent on imports , sending that money abroad instead of keeping it in the local economy.
Can Create Budget Deficits A government budget deficit is when it spends more money annually than it takes in. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.
We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
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Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. Monetary policy is a set of actions available to a nation's central bank to achieve sustainable economic growth by adjusting the money supply.
What Is Fiscal Policy? Fiscal policy uses government spending and tax policies to influence macroeconomic conditions, including aggregate demand, employment, and inflation. Quantitative Easing QE Quantitative easing QE refers to emergency monetary policy tools used by central banks to spur iconic activity by buying a wider range of assets in the market.
Tight Monetary Policy A tight monetary policy refers to central bank policy aimed at cooling down an overheated economy and features higher interest rates and tighter money supply. Pushing On A String Definition Pushing on a string is a metaphor for the limits of monetary policy when households and businesses hoard cash in the face of a recession. What Is a Stimulus Package? A stimulus package is a package of economic measures put together by a government to stimulate a struggling economy.
As such, those countries with a level of debt that had not been sufficiently reduced in the years prior to the crisis Greece is a clear example had to face the recession from a delicate starting point. As a result, they were unable to implement expansionary fiscal policies to moderate the decline in economic activity, since this would have jeopardised the sustainability of public debt. The fiscal policy of these countries ended up being procyclical, since they had to adjust their public accounts during the recessive phase of the cycle, instead of making these adjustments during the years prior to the crisis, when the economy was growing above its potential.
On the contrary, those countries whose fiscal policies allowed them to have relatively low levels of debt prior to the recession Germany is a good example were able to mitigate the impact of the crisis without jeopardising their capacity to repay their sovereign debt. Ten years after the outbreak of the crisis, it is natural to wonder about the current situation.
In short, we do not know exactly when the next recession will come, nor how deep it will be. We also do not know whether we will then be able to answer a question similar to that posed by Queen Elizabeth II in What we do know is that, in the past, several decisions were taken which we can now say were incorrect, partly due to opting for the wrong recipes and partly due to a misreading of what phase in the cycle we were in at the time. Although the measures that have been taken since the financial crisis have been aimed at correcting these errors, the response of fiscal and monetary policy to the crisis has also left us with less capacity to respond to future crises high public debt, very low interest rates, central banks with unprecedented balance sheet volumes, etc.
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