1. critically examine the effectiveness of monetary policy.
2. what factors do you think limit the effectiveness of monetary policy.
Previously, I have written an essay – what determines the effectiveness of monetary policy
In brief, the aim of monetary policy is to target low inflation (CPI = 2% +/-1). But, also to maintain a steady rate of economic growth. In recent months it has been difficult for the Bank of England to achieve both these objectives. This is because we have had cost push inflation (rising oil, food prices). The cost push inflation causes rising prices and falling economic growth. Therefore, even though inflation has increased to over 4%, the Bank don’t want to increase interest rates because the economy is already slowing down. Therefore, they have left interest rates the same and have been unable to keep inflation on target.
However, in period 1997-2007, monetary policy effectively kept economic growth and inflation stable. This was because cost push inflation was low and the independent Bank of England was successful in preventing growth exceeding the long run trend rate.
However, in the great moderation, despite low inflation, there were imbalances in the economy – such as rising house prices and boom in credit. This shows limit of monetary policy in preventing credit bubble.
Between 2007 and 2011, monetary policy became much more difficult. This was because of:
Cost push inflation and recession. In 2008 and 2011, the UK experienced a rise in CPI inflation to over 5%. (see: cost push inflation) Yet, at the same time, economic growth was very low or negative. This present the Bank of England with a difficulty. On the one hand, inflation is above their target so they should consider raising interest rates. However, with a depressed economy, the economy needs the opposite.
Liquidity Trap In 2008, the economy was in a liquidity trap. Cutting interest rates to zero, failed to boost spending and economic growth. Therefore, the Bank of England were forced to pursue quantitative easing.