Lesson 7 of 8 · All lessons in this module
- What central banks do and what they aim for
- The three tools: open market operations, policy rate, reserve requirements
- How a rate change reaches growth, inflation and the currencyVideo lesson
- Effective central banks and inflation targeting
- Exchange rate targeting and policy in developing economies
- Expansionary or contractionary? The neutral rate and the source of shocks
- Limits of monetary policy: weak transmission, deflation and quantitative easingVideo lesson
- How monetary and fiscal policy interact
Lesson 7 of 8 · 15 min
Limits of monetary policy: weak transmission, deflation and quantitative easing
Monetary policy can fail when long rates or banks do not respond as intended, and above all in deflation, where rates cannot go much below zero; quantitative easing is the large-scale asset-buying response, with no guarantee of success.
In short
- Transmission can break: a rate hike that lowers inflation expectations can make long-term rates fall, easing conditions instead of tightening them.
- Bond market vigilantes push long yields up if they think the central bank is losing control of inflation, or down if they expect tight policy to cause a slowdown. A credible bank does not need them.
- Liquidity trap: money demand becomes infinitely elastic, so extra money no longer lowers rates or lifts activity. Linked to deflation.
- Deflation raises the real value of debt and encourages people to delay spending: a self-reinforcing trap, and rates cannot be cut much below zero.
- Quantitative easing (QE): open market purchases on a very large scale, of government bonds, mortgage bonds or other assets. It is expansionary but works only if banks lend and people spend.
- Ultimate limit: central banks control neither how much people deposit nor how willing banks are to lend, so they cannot fully control the money supply.
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