Is expansionary monetary policy just as effective as contractionary monetary policy?



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Posted on (Answer #1)

While it is hard to know this for sure, contractionary monetary policy is more likely to be effective than expansionary monetary policy is.  This is because contractionary monetary policy requires less cooperation from entities other than the central bank.  As a way of understanding this, let us look at the monetary policy that was pursued by the Fed as a way of trying to pull the US economy out of the “Great Recession.”

When the US economy crashed, the Fed, of course, tried to use expansionary monetary policy to help the economy get restarted.  In particular, it lowered interest rates as far as it could.  This did not end up helping the economy in any very significant way.  When the Fed lowers interest rates, it hopes to stimulate the economy by allowing banks to lend more cheaply.  When banks are lending cheaply, more people and companies will want loans and more loans will be made.  The problem is that this did not happen.  Banks did not want to loan.  They were afraid that the loans would go bad, also they were afraid of the mounting bank closures.  Therefore, even though rates dropped and people wanted loans, the banks did not want to provide them.  This made the Fed’s expansionary policies much less effective than they could have been.

Thus, expansionary policy depends on borrowers and lenders playing their parts.  This means that it is less reliably effective than contractionary policies are.

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