Limitations of Monetary Policies

Today, I was teaching monetary policies to my students and realized that many IGCSE Economics textbooks do not discuss the limitations of monetary policies clearly. I set out below clearer explanations. 

Some limitations of monetary policy include:

• Liquidity Trap – This occurs when a cut in interest rates fail to stimulate economic activity. e.g. because of low confidence in the economy or banks don’t want to pass base rate cut to consumers.

• Difficult to control many macroeconomic objectives with one tool – interest rates. For example, a rise in oil prices causes cost-push inflation. Central banks could increase interest rates to reduce inflation, but, it would cause economic growth to fall as well.

• Changing interest rates affects the exchange rate. Tight monetary policy causes an appreciation in the exchange rate which will make exports less competitive.

• Interest rates may affect some people more than others. e.g. higher interest rates increase the disposable income of people with savings. But, could cause homeowners to default on their mortgage payments.

• Time lags – it can take up to 18 months for the effects of any changes in interest rates to filter through the economy. This makes it hard to set the right policies since what is right now may not be right 18 months later.