ii) even if monetary policy was effective, its efficiency would be dependent on a series of other factors, starting with the level of fiscal deficit. If the public debt is not sustainable, an easing of monetary policy arouses fears that an inflationary tax will be used to finance the debt. Financial markets would attach a higher risks to government bonds, and will demand a higher risk premium. Interest rates would soon rise again and economic recovery would be postponed.
iii) the relationship between interest rates and inflation is lagged. Monetary policy operates with a delayed reaction of 1-2 years. To be credible, the central bank has to react, not to the present level of activity and inflation, but to their expected values in 1-2 year time. Due to future uncertainty, volatility of expectations and faulty forecasts, such 'fine-tuning' policy requires good judgement to implement successfully - hence the art of central banking.
However, an easing of monetary policy usually helps the recovery after a recession. Monetary authorities try to influence commercial interest rates through:
i) direct controls: credit guidelines, interest regulations, administrative controls.
ii) market-based controls: open-market operations (supplementing liquidity to the system), official discount rate changes (decreasing the rate at which commercial banks borrow from the central bank), changes in reserve requirements (decreasing the minimum reserve required to commercial banks).
Market based controls are preferred to direct controls because they avoid the problem of disintermediation.
Q2 An investment report opened its 'investment outlook' section with the comment:
We expect the global economic environment to be characterised by moderate economic growth and relatively low inflation, a combination which should lead to relatively low interest rates also.
Is this statement referring to (a) the real interest rate, (b) the nominal interest rate or (c) to both? Explain.
In this situation, both interest rates are likely to be low. Since inflation is low, nominal interest rates will be low relative to a high inflation environment. And, since economic activity is moderate, demand for capital is likely to be restrained and therefore real interest rates are also likely to be low. If the economy is small, however, the level of real interest rates will depend on external in addition to internal factors.
Q3 An investment report written in 1996 warned that:
There is a fear that, for political reasons, the UK government will 'go for growth' over the life of this Parliament by increasing spending and cutting taxes while being more lax about interest rates, thus fuelling inflation. That said, the feeling that interest rates have been raised at an earlier stage than in previous recoveries improves the likelihood that inflation will be kept under control.