Introduction
Monetary policy is the process of government control on the economy through monetary instruments. The monetary authority in the economy uses the tools of monetary policy to affect demand and supply of money with the objective of fostering growth and maintaining price stability in the economy along with financial market stability. The instruments of monetary policy include rate of interest and open market operations. In this paper we attempt to show that monetary policy is effective in the short run but not in the long run. We use two different models to establish our argument, the AD/AS model and the IS/LM model. We begin with a brief description on how monetary policy affects growth and stability in the economy in the next section. In section III we discuss the effectiveness of the monetary policy in the short run and long run through the AD/AS model and in section IV we discuss the effectiveness in terms of the IS/LM model. The fifth section is the concluding part of our paper.
Impact of Monetary Policy
Monetary policy instruments include rate of interest and open market operations. There are other instruments such as the cash reserve ratio. Since interest rate and open market operations are mostly used by the central bank in an economy we restrict our discussion to these two policy instruments. With an increase in the rate of interest the demand for money falls as people prefer to keep the money in bank rather than take loans for making expenditures. The flow of credit in the economy falls. Lower expenditures reduce the price level and output . Thus income output and price falls. With a fall in the rate of interest the flow of credit in the economy increases as people do not prefer to keep money in the bank. Taking loans become cheaper. This induces more spending. People prefer to invest their savings in equities and shares. Thus investment and consumer expenditures increase. The increased spending increases aggregate demand thereby raising the price level. The higher price level induces producers to increase production. The increased production raises total output in the economy. More jobs are created resulting in the fall in unemployment. Income increases. Thus a fall in the rate of interest results in the rise in price, output and employment in the economy.
Open market operations involve sale and purchases of government bonds in the open market by the central bank. As the central bank purchases more bonds, money supply in the economy increases . The banks are able to advance more loans leading to increased spending in the economy. This results in higher output and employment. When the economy faces an inflationary situation the central bank follows a policy of monetary tightening. It sells government bonds in the open market thereby restricting money supply in the economy. Credit flow in the economy is reduced. The banks have less liquidity to give out as loans. Spending gets reduced resulting in a fall in the aggregate demand. The price level falls so does output and employment. Let us now discuss how the monetary policy is effective in the short and long run in the next two sections.
Monetary Policy in the AD/AS Model
Short Run
As monetary expansion takes place through the fall in the rate of interest the aggregate demand increases through the increase in investment and consumer expenditure . This is shown by a rightward shift in the AD curve from AD0 to AD1 in figure 1. The price level and output increases. In the short run the aggregate supply increases with the increase in the price level. So, the AS curve is upward rising. As AD increases, the increase in the price level leads to increase in supply along the AS curve. Thus output increases. We can see that monetary policy is effective in the short run.
Long Run
In the long run the economy reaches near full employment. Since all the resources are fully utilized the supply cannot be increased even when the price level rises. The aggregate supply curve, AS becomes vertical as shown in figure 2. With a monetary expansion the AD curve shifts to the right from AD0 to AD1 (figure 2). The price level rises but output does not rise. Thus monetary policy is ineffective in the long run.
Effectiveness of Monetary Policy: IS/LM Model
The IS curve represents the equilibrium in the product market. It is downward sloping as the increase in rate of interest r leads to the fall in the income level Y. The LM curve represents the equilibrium in the money market. It is positively sloped as increase in the interest rate leads to fall in the demand for money. Real balances remaining the same a rise in the income level Y can restore money market equilibrium.
Short Run
In the short run as the central bank takes up the policy of monetary expansion the LM curve shifts to the right as shown in figure 3. The rate of interest falls and output/income increases. Thus monetary policy is effective in raising the output level in the economy.
Long Run
In the long run the economy is near full employment level. The IS curve becomes steeper as the fall in the interest rate has less impact on the output level. As the LM curve shifts to the right due to expansionary monetary policy the rate of interest falls but output increase to a small extent as shown in figure 4. Thus monetary policy is ineffective in the long run.
Figure 1
P AS
AD0 AD1
Y0 Y1 Y
Figure 2
P AS
AD1
AD0
Y
Figure 3
r LM0
LM1
IS
Y0 Y1 Y
Figure 4 LM0
r LM1
IS
Y0 Y1 Y
Conclusion
In this analysis we have shown that though monetary policy is effective in the short run it has little effect in the long run. The primary reason for the ineffectiveness of the monetary policy is that in the long run the output cannot be increased even if the price increases or rate of interest falls. In the long run fiscal policy will be more effective. It is more important to invest in technological improvement so that productivity is improved.
In both AD/AS and IS/LM model we have seen that monetary policy is unable to increase output in the long run. Monetary expansion leads to increase in the price only in the AD/AS model. In the IS/LM model we can see that the rate of interest falls but output does not increase significantly. Thus in both the models we can see that output fails to increase even when the central bank takes a monetary easing policy in the long run.
References
Branson, W. H. (1989). Macroeconomic Theory and Policy. McGraw Hill.
Mankiw, G. (2013). Macroeconomics. Macmillan.
