Explain the constraints on what monetary policy can achieve
The idea
Monetary policy acts with long and variable lags, so a rate change today affects output and inflation over the following year or two, requiring the bank to act on forecasts rather than current data. Near the zero bound conventional easing runs out of room. In a liquidity trap, cheap money fails to stimulate because households and firms hold the extra money rather than spend or borrow it. Policy also works largely through credit, so an impaired banking system blunts transmission. And it is a blunt instrument: the rate that suits an overheating region may be badly wrong for a weak one.
A practice question
Why must central banks act on forecasts rather than current conditions?
- Because current data are never publishedWhy not: They are published continuously; the problem is that acting on them is acting too late.
- Because policy affects the economy only after a long and variable lag — correct
- Because forecasts are more accurate than dataWhy not: Forecasts are considerably less accurate. They are used despite that, because the lag leaves no alternative.
By the time a rate change works through, conditions will have moved on. Setting policy for today's data would consistently be setting it for the wrong moment.
A harder one
Why does an impaired banking system blunt monetary policy?
- Because policy works largely through credit, and damaged banks do not pass the easing on — correct
- Because impaired banks hold more reservesWhy not: They often do, but hoarding reserves is a symptom of the unwillingness to lend rather than the reason policy fails.
- Because the policy rate cannot be changed during a banking crisisWhy not: It can be, and usually is, sharply. The difficulty is that the cut does not reach borrowers.
Transmission depends on intermediaries, and the instrument reaches the economy only through them.
The hardest tier
Why does a monetary union face a particular version of monetary policy's bluntness problem?
- Because member states cannot use fiscal policyWhy not: They retain it, and it is often the only stabilising instrument left to them.
- Because exchange rates float within the unionWhy not: There are no internal exchange rates to float, which is precisely the source of the difficulty.
- Because a single rate must serve economies at different points in their cycles — correct
One policy rate cannot be right for a booming member and a contracting one at the same time. Without independent currencies or large fiscal transfers, the adjustment falls on domestic wages and prices instead.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →