Monetary policy is not the
only force acting on output, employment, and prices. Many other factors affect
aggregate demand and aggregate supply and, consequently, the economic position
of households and businesses. Some of these factors can be anticipated and built
into spending and other economic decisions, and some come as a surprise. On the
demand side, the government influences the economy through changes in taxes and
spending programs, which typically receive a lot of public attention and are
therefore anticipated. For example, the effect of a tax cut may precede its
actual implementation as businesses and households alter their spending in
anticipation of the lower taxes. Also, forward looking financial markets may
build such fiscal events into the level and structure of interest rates, so that
a stimulative measure, such as a tax cut, would tend to raise the level of
interest rates even before the tax cut becomes effective, which will have a
restraining effect on demand and the economy before the fiscal stimulus is
actually applied.
Other changes in aggregate
demand and supply can be totally unpredictable and influence the economy in
unforeseen ways. Examples of such shocks on the demand side are shifts in
consumer and business confidence, and changes in the lending posture of
commercial banks and other creditors. Lessened confidence regarding the outlook
for the economy and labor market or more restrictive lending conditions tend to
curb business and household spending.
In practice monetary policy makers do not have up to the minute information on the
state of the economy and prices. Useful information is limited not only by lags
in the construction and availability of key data but also by later revisions,
which can alter the picture considerably. Therefore, although monetary policy
makers will eventually be able to offset the effects that adverse demand shocks
have on the economy, it will be some time before the shock is fully recognized
and (given the lag between a policy action and the effect of the action on
aggregate demand) an even longer time before it is countered. Add to this the
uncertainty about how the economy will respond to an easing or tightening of
policy of a given magnitude, and it is not hard to see how the economy and
prices can depart from a desired path for a period of time.
The statutory goals of
maximum employment and stable prices are easier to achieve if the public
understands those goals and believes that the Federal Reserve will take
effective measures to achieve them. For example, if the Federal Reserve
responds to a negative demand shock to the economy with an aggressive and
transparent easing of policy, businesses and consumers may believe that these
actions will restore the economy to full employment; consequently, they may be
less inclined to pull back on spending because of concern that demand may not be
strong enough to warrant new business investment or that their job prospects may
not warrant the purchase of big ticket household goods. Similarly, a credible anti inflation policy will lead businesses and households to expect less wage
and price inflation; workers then will not feel the same need to protect
themselves by demanding large wage increases, and businesses will be less
aggressive in raising their prices, for fear of losing sales and profits. As a
result, inflation will come down more rapidly, in keeping with the
policy related slowing in growth of aggregate demand, and will give rise to less
slack in product and resource markets than if workers and businesses continued
to act as if inflation were not going to slow.
Back
Limitations of Monetary Policy
Back to
Test