Is monetary policy alone enough to stimulate economic recovery? 

Earlier economists believe that economy is self sufficient to retain its equilibrium. Later on Keynes told that government intervention is necessary to bring the economy on track. But after sometime economist discovered a one more tool, which became a master weapon for the central bank to make economy growth smoother. And the name of this weapon is monetary policy. And the government intervention is termed as fiscal policy. Now there is lot of debate going on the world which one is superior in fighting against recession.

                     But I think fiscal policy and monetary policy are the left and right hand of the country. Both are necessary for achieving economy growth and also in a long run. We can’t win our war against recession by fighting with only one tool; we need a combined effort or effects of both tools. The only difference is that right hand (monetary policy) work fast it gives quick result i.e. we can use it for a short term. And the left hand (fiscal policy) will take a time to give better results i.e. it is most important for long term planning and growth.

                 Now the question arises, why monetary policy alone is not enough? We will discuss this question step by step. First of all it is important to know the types of monetary policy based on the goals achieved via monetary policy. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals. The various types are inflation targeting, price level targeting, monetary exchanges, mixed policy, etc. Since the main objective of monetary policy is price stability, policy changes are expected to influence the inflation rate, and the policy stance is also triggered by the ruling and expected inflation rates. Monetary policy has two basic goals: to promote price stability by keeping inflation low, and to promote sustainable economic output and employment. It’s totally depending on the country which type of monetary policy it chooses. For e.g. Australia, Canada, UK, etc. is using inflation targeting and country like India uses multiple indicator approach.

                 The most important monetary policy tools are: Open market operations, reserve requirements, Discount window lending, interest rates and currency boards. First we take the open market operation (OMO) tool, how much it is effective and what are its limitations. OMO, which involve the buying and selling of government bonds on the open market, mainly use to suck or infuse the liquidity in market. The main aim is to strengthening or weakening the lending capacity of commercial banks. The central bank can’t perform the OMO on large scale because it directly affects the reserves of the commercial banks and their capacity of lending. And it directly affects the economic growth, so the central banks have to do a trade-off between economic growth and inflation. This limitation restricts the use of OMO on large scale.

                           

                      Secondly the changes in reserve requirements are another tool of the central bank to fight with inflation and during the down turn of economy. By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply. The major disadvantage of using this tool is for large changes in reserves approval must be required from the ruling party of the country. And also large changes cannot be made quickly and easily. Changes in reserve requirement will create a lot of problems for commercial banks especially in their liquidity management.

                       Thirdly, the discount window lending, in this bank receives a loan from the central bank at a discount rate. In this case we can infuse liquidity in the market and at the same time we are also pushing inflation. This is used by central banks in a very cautious way; excessive discounts on loans will fuel the inflation. And our ultimate objective of price stability is not fulfilled.

                       Fourthly, the interest rates, it operates in two direction – tightening and easening – counteracting the pressures of the economic cycle, so that economic activity is sustained over a period with a moderate inflation rate. This tool directly affects the investment and saving pattern of the economy. The limitation of this tool is that central bank can’t cut the interest rate beyond zero, in this situation, if central bank trying to stimulate the economy by injecting more money or liquidity through open market operations may have little or no effect on output. Therefore, it may appear that monetary policy is impotent under these conditions. This creates a condition of liquidity trap. When the economy is in a recession (when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest rate policy they faced a situation of liquidity trap. In this case, fiscal policy might be more effective in stimulating demand.

                      Fifth and the last tool is currency board or exchange rate. An economy cannot simultaneously observe an open capital account, a fixed exchange rate and an independent monetary policy. The logic is straightforward. If an emerging market were to fix its exchange rate, and then engage in a monetary stance different from developed markets (hike rates when developed markets are easing, for e.g.), capital flows would move swiftly and sharply to take advantage of the interest rate differential and thereby undermine the original monetary stance of the emerging markets (by forcing an accumulation of foreign currency reserves and creation of base money that undermines the original tightening). Conversely if an emerging market were to unilaterally cut interest rates, a large capital outflow would result, draining reserves and making the fixed exchange rate untenable. Countries that have tried to have their cake and eat it too, over any length of time, have ended in tears. Just ask the Thai authorities about 1997.

                          Maintaining an independent monetary policy is equally crucial to maintaining macroeconomic stability. As we have painfully found out over the last two years, domestic factors have been important drivers of inflation. So even as the Fed and ECB were easing policy through 2010 and 2011, RBI was forced to go to the other way – hike rate 13 times! Recent events in Europe have given birth to another trilemma for central banks around the world. The issue is this: the 2008 crisis made clear that central banks cannot focus exclusively on price stability. Their mandate must broaden to include financial stability as well. If that wasn’t enough, events in Europe have demonstrated that monetary policy has become subordinate to fiscal policy whereby the ECB has been forced to increase the size of its balance sheets to help make sovereign debt less unsustainable. The problem is that these three goals – price stability, financial stability, sovereign debt sustainability – are simultaneously incongruous for a central bank. You can simultaneously achieve two of these objectives. Not all three. These economies have boxed themselves into a corner where monetary policy is hostage of fiscal policy.

                          As of now the problem Greece faces is that it does not have  a currency of its own that it can mint it, it cannot devalue and it does not have the right to impose protectionist barriers against euro zone members. It needs to be allowed to do that by its partners, who must infuse liquidity on terms and in volumes that give the government a chance to push for recovery through means that are also politically possible. A grand experiment in monetary union without political union that some always saw as the temporary triumph of political will over economic constraints – is now unraveling. The reasons are partly related to the very design of the eurozone; it is rare, if not impossible, to find long lived example of monetary union that do not have a significant degree of fiscal federalism explicitly incorporated in them. With the exchange rate removed as a potential policy instrument, current account imbalances between different regions of the common currency area may rapidly become unsustainable if fiscal transfers are not assured.

         There is a crucial difference between the Fed, ECB and RBI expanding their balance sheets. The former are doing so in economies with a lot of slack in factor markets and inflation below targets. In India we face a very different environment. Given the stubbornly high inflation pressures that we have faced, any attempt by RBI to accommodate large government borrowings creates liquidity likely to fuel more inflationary pressures and expectations – the last thing this economy needs. The goal of India’s central bank must be clear – focus on price and financial stability and avoid the fiscal dominance of monetary policy. The failure of EUROZONE is the live example of limitations of monetary policy or we can say this clearly shows that monetary policy is not alone enough to stimulate economic recovery.

By:- Sumit singh

sumitsingh17@gmail.com