Cambridge International as and a level Economics Ebook

The eff ectiveness of monetary policy
In practice, it can be diffi
cult to control the money 
supply. Th
is is partly because commercial banks have 
a strong incentive to try to increase their lending and 
may seek to get round any limits a central bank seeks to 
impose on the growth of their lending. Trying to control 
certain forms of money may lead to new forms of money 
being used.
Using interest rates is also not without problems. 
Th
ere is a time lag between changing interest rates and 
the full eff ect being transmitted to the macroeconomy. 
Some economists have estimated that it can take as long 
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Cambridge International AS Level Economics

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as 18 months for interest rate changes to have their full 
impact. Th
is is, however, less time than in the case of some 
fi scal policy measures.
Interest rate changes may be a powerful policy 
measure but they are also a blunt and uncertain one. 
Some households and fi rms are more likely than others 
to cope with a change in the interest rate. For example, a 
rise in the rate of interest harms borrowers but benefi ts 
savers. A higher interest rate may also have an adverse 
eff ect on unemployment and economic growth, as with a 
defl ationary fi scal policy measure.
With increasing mobility of fi nancial expenditure, it 
can be diffi
cult for a country to operate an interest rate 
that is signifi cantly diff erent from rival countries. If, for 
example, the country reduces its rate of interest to a level 
noticeably lower than that of its rival countries, hot money 
may fl ow out of the country.
A rise in the rate of interest may discourage foreign 
direct investment as it would raise foreign fi rms’ costs and 
the fi rms may expect demand to fall in the country.
Th
ere are also challenges in using the exchange rate to 
infl uence the balance of payments position. For example, 
lowering the exchange rate will not work if demand for 
exports and imports is price inelastic or if the relative 
quality of the country’s products falls.
As with fi scal policy measures, most monetary 
policy measures are not likely to be an eff ective long-
term solution to balance of payments problems. Th
e 
one exception may be a government deciding to stop 
maintaining an exchange rate that is set above or below 
the market value. For example, if a central bank has been 
keeping an exchange rate above its equilibrium level, the 
high export prices and low import prices may have led 
to a current account defi cit. In this case, allowing the 
exchange rate to increase to its market rate may reduce 
the country’s defi cit.
TOP TIP
In considering the impact of deflationary fiscal and 
monetary policy measures, it is useful to consider the 
initial level of economic activity.