Limitations of Monetary Policy

However, suppose some traders (the bond market vigilantes) do not agree with your assessment, thinking the economy is not slipping into recession. Instead, they believe lower short-term interest rates will be inflationary. As a result, they dump their long-term bonds. As bond vigilantes sell their long-term bonds, what do you suppose happens to the yields on long-term bonds?

Incorrect. As bond vigilantes sell their long-term bonds, the price of long-term bonds falls.

Incorrect. As bond vigilantes sell their long-term bonds, price and yield will change.

Correct. As bond vigilantes dump their long-term bonds, long-term bond prices fall and yields rise. Although your short-term interest rate cut puts downward pressure on long-term rates, the response of the bond vigilantes puts upward pressure on long-term rates, limiting the effectiveness of your monetary policy by hampering the monetary policy transmission mechanism.

Another scenario in which the monetary policy transmission mechanism may not operate perfectly is in a __liquidity trap__. A liquidity trap is an extreme case where the demand for money is perfectly elastic, meaning that people are only willing to hold new money as money balances, regardless of the interest rate. Suppose that Fakesylvania is in a recession. As a monetary policy response, you increase the money stock. If Fakesylvania is caught in a liquidity trap, what happens to that new money?

Incorrect. In a liquidity trap, people are only willing to hold new money as money balances. They do not lend it out, so it is not invested.

Correct. In a liquidity trap, people are only willing to hold new money as money balances. They do not lend it out, so it is not invested.

Typically, liquidity traps occur in a deflationary environment. Deflation limits the effectiveness of conventional monetary policy. Suppose that Fakesylvania is in a recession and is facing deflation. You, the Chairperson of the Central Bank, have cut short-term interest rates to record-low levels. But deflation is persistent, so you plan on cutting them even further. What do you suppose is the lowest level that you can cut nominal short-term interest rates to?

Incorrect. You could cut nominal short-term rates even further than 1%. For example, 0.5% or even 0.25% are possibilities.

Yes! A 0% rate is the lowest rate historically possible for nominal short-term interest rates. It is said that interest rates have a _zero lower bound_ (although this has been broken with some extraordinary measures in recent years). This is generally a limitation for monetary policy, because if they've already cut interest rates to as low as they can go, there is not much more conventional monetary policy can do if the economy continues in a deflationary recession. One solution pioneered in Japan in the 1990s and used in the response to the 2008–2009 recession in the United States is __quantitative easing__. Quantitative easing is an unconventional monetary policy tool in which the central bank purchases vast quantities of long-term bonds, the idea being that purchasing so much long-term debt causes the price of long-term bonds to rise.

Incorrect. Rates have been lower than 2% in recent years.

Suppose you try quantitative easing in Fakesylvania. As the price of long-term bonds rises with central bank purchases, what should happen to long-term interest rates?

Incorrect. Recall that bond prices and yields are inversely related.

Incorrect. Massive intervention by the central bank surely has some impact on the long-term bond market.

That's right. The idea is that long-term bond debt purchases by the Central Bank of Fakesylvania may put downward pressure on long-term interest rates, spurring economic activity.

Congratulations! Despite the limitations of conventional monetary policy, you have successfully navigated the perilous waters of a modern economy. You are an excellent fictional central banker!

To summarize: [[summary]]

Thus, if the economy is in a liquidity trap, the monetary policy transmission mechanism fails and the central bank cannot adjust interest rates. The new money is not lent out, so interest rates are not affected by the monetary expansion. Without being able to influence the interest rate, the central bank will find monetary policy to be ineffective.

Suppose that you are the Chairperson of the Central Bank of Fakesylvania. Although your policy decisions have a large impact on the economy, there are limits to the power of monetary policy. The first example of these limits is that the monetary policy transmission mechanism may not always function perfectly. One reason may be the existence of __bond market vigilantes__. Suppose that you, the Central Bank Chairperson, believe that Fakesylvania may be sliding into a recession. As a response, you lower short-term interest rates, putting downward pressure on long-term rates.

Yields fall

Yields remain the same

Yields rise

It is invested

People sit on it

1%

0%

2%

They should fall

They should rise

They should remain unchanged

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