Will Monetary Policy Work

Monetary policy tries to control inflation and economic growth by changing interest rates. However, changing interest rates may be ineffective in influencing economic growth. This is because:

1 Time Lag. It can take upto 18 months for changes in interest rates to effect the economy. This is because people do not make decisions about borrowing straight away. If you have an investment project started you will finish it and not stop just because interest rates have gone up.

2. It depends who you are. E.g. Savers may spend more because they get higher interest payments. However, borrowers will be worse off. If a country has a low savings ratio then higher rates will have a big effect in reducing spending.

3. It depends on other factors affecting the economy. For example, if consumer confidence is very low, higher interest rates may be ineffective in reducing demand.

4. Monetary Policy can only target one thing at a time. For example, if there is cost push inflation, we get higher inflation and lower economic growth. Therefore, monetary policy cannot solve both at once. Supply side hocks make monetary policy quite difficult.

5. The MPC only target inflation therefore they may ignore other problems such as a boom and bust in the housing market.

6. The MPC may have poor information about the state of the economy. e.g. in early 2008 the MPC were predicting high growth and so kept interest rates high. However, growth was much worse than predicted

7. Depends on credibility of monetary policy. If the public have confidence in the Central Bank. If people expect the inflation target to be met, then monetary policy becomes more effective. Arguably, an independent central bank has more credibility than the government.