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Effectiveness of monetary policy

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Effectiveness of monetary policy

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tiwariabhyomi
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The Effectiveness of Monetary Policy in the

Short Run vs. Long Run


Monetary policy, managed by central banks (e.g., the Federal Reserve, ECB),
influences economic activity through interest rates, money supply, and credit
conditions. Its effectiveness varies significantly between the short run and long
run, depending on economic theories (Keynesian vs. Classical) and real-world
constraints.

1. Short-Run Effectiveness
In the short run, monetary policy is highly effective due to:

A. Keynesian Transmission Mechanisms

1.​ Interest Rate Channel​

○​ Lower policy rates → cheaper borrowing → higher consumption (C)


and investment (I).​

○​ Example: The Fed’s rate cuts during the 2008 crisis revived lending.​

2.​ Liquidity Effect​

○​ Increased money supply reduces nominal interest rates, stimulating


demand.​

3.​ Exchange Rate Channel​

○​ Lower rates depreciate currency → boosts net exports (X-M).​


4.​ Wealth Effect​

○​ Lower rates raise asset prices (stocks, housing) → higher consumer


spending.​

Empirical Evidence:

●​ The U.S. Federal Reserve’s response to COVID-19 (2020) prevented a


deeper recession by cutting rates to near-zero and implementing QE.​

B. Limits in the Short Run

1.​ Liquidity Trap​

○​ Near-zero rates limit further stimulus (e.g., Japan since the 1990s).​

2.​ Sticky Expectations​

○​ If consumers/firms expect deflation, rate cuts may fail to spur


spending.​

Graph: Short-Run Monetary Policy (IS-LM Model)


●​ ​

2. Long-Run Effectiveness
In the long run, monetary policy is neutral (Classical view):

A. Classical Proposition

1.​ Money Neutrality​

○​ MV=PYMV = PY (Quantity Theory of Money): Money supply


growth only raises prices, not real output.​

2.​ Natural Rate Hypothesis​

○​ Output returns to potential GDP (Y*), regardless of monetary policy


actions.​

Example:

●​ In the 1970s, the Fed’s expansionary policies led to stagflation (high


inflation + high unemployment), validating Milton Friedman’s critique.​

B. Long-Run Limits
1.​ Inflation Targeting​

○​ Persistent money growth beyond real GDP growth causes


hyperinflation (e.g., Zimbabwe, Venezuela).​

2.​ Rational Expectations​

○​ If agents anticipate inflation, wage-price spirals neutralize stimulus


effects.​

Graph: Long-Run Neutrality (AD-AS Model)

●​ (Insert diagram with vertical LRAS curve; AD shifts affect price levels, not
output.)​

3. Policy Implications

Scenario Short-Run Impact Long-Run Impact

Rate Cut Increases Output, Decreases Increases Inflation, No


Unemployment change Output

Rate Hike Decreases Output, Increases Decreases Inflation, No


Unemployment change Output
Quantitative Easing Increases Asset prices, Risk of asset bubbles
Decreases Rates

Case Studies

1.​ 2008 Crisis (Short-Run Success)​

○​ Fed’s near-zero rates + QE stabilized financial markets and prevented


a depression.​

2.​ Volcker Shock (Long-Run Discipline)​

○​ Extremely high interest rates (early 1980s) successfully crushed


inflation but caused a severe recession.​

4. Modern Debates
1.​ New Keynesian View​

○​ Short-run stickiness (prices/wages) allows persistent real effects of


monetary policy.​

2.​ Monetarist Critique​

○​ Long and variable policy lags can destabilize rather than stabilize the
economy.​
Key Takeaway
●​ In the short run, monetary policy is a powerful tool for demand
management and stabilizing economic cycles.​

●​ In the long run, it only impacts nominal variables like inflation and has no
effect on real growth.​

References
1.​ Friedman, M. (1968). The Role of Monetary Policy.​

2.​ Bernanke, B. (2020). The New Tools of Monetary Policy.​

3.​ ECB (2021). Monetary Policy and Inflation Control.​

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