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What Factors Influence the Effectiveness of Monetary Policy?

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  • Written By: John Lister
  • Edited By: O. Wallace
  • Last Modified Date: 29 July 2014
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Monetary policy involves decisions taken by a government or central bank to attempt to influence the economy by influencing the availability of money and the cost of credit. There is an ongoing debate about the inherent effectiveness of monetary policy and its fundamental limitations. There are also practical issues that affect the effectiveness of monetary policy such as interaction with other currencies and the nature of the banking sector in the country concerned.

There are three main areas of monetary policy. The first is controlling the amount of money in circulation, whether this involves literally printing money, or more technical measures such as quantitative easing, which involves creating money in the form of credit. The second measure is using interest rates to influence what people and businesses pay to borrow or receive for saving, which can affect their spending and investment levels. The third measure is attempting to influence the exchange rate between the national and foreign currencies, which can involve fixing or restricting exchange rates, or buying and selling currency to influence the market rate. Measures such as government spending and taxation fall into the separate category of fiscal policy.

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The basic question of how effective monetary policy is compared with fiscal policy is one of the major debates in economics. Most economic views can crudely be divided into the pro-fiscal control position advocated by economists such as John Maynard Keynes and the pro-monetary controls position of economist such as Milton Friedman. As a very gross simplification, monetarists believe monetary policy is inherently effective and its role is to allow markets to be as free as possible. Keynesians believe that economic cycles can cause hitches in free markets, meaning that fiscal policy is often needed to "kick-start" the economy. Such debates often have a political element based on people's view of the role of government in society.

Another inherent limit on the effectiveness of monetary policy is that two of its main aims can be contradictory. Monetarists often seek to keep both inflation and interests rates low and under control. The problem is that low interest rates mean homeowners pay less for their mortgages and have more spare cash, which can contribute to rising inflation.

There are also specific practical factors affecting the effectiveness of monetary policy. How successfully governments or banks can control exchange rates depends on economic and political arrangements. For example, the individual countries that all use the Euro have limited monetary policy powers over its exchange rate. Meanwhile attempting to influence the exchange rate by buying or selling currency can be dependent on the financial strength of the government or bank, along with that of other countries and even large individual and corporate traders.

The effectiveness of interest rate controls is also variable. In most capitalist, free-market economies, the government or central bank does not directly control the interest rates banks charge to customers. Instead the government or central bank determines the rate commercial banks pay to borrow overnight to deal with the variations in cashflow caused by deposit and loan levels varying from day to day. In theory this rate makes up a major cost for commercial banks and influences the rates they must charge on loans to maintain profits. In practice, the rates charged to customers can depend largely on how competitive the banking market is.

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