Forex Educational Library

Limitations On Monetary Policy


Macroeconomics currently has different models to analyze how markets behave, which relationship has different indicators and what effect the application of certain policies could have. But the problem with the theory is that it does not consider all the variables that really affect, and a principle of the models is the simplicity and because there are variables that behave differently than would be expected. This mainly occurs with the expectations of people because it is a variable that cannot be controlled and can behave very differently than would be expected.

In the last century, various models have been developed to explain economic behavior, but it is still far from perfection. When central banks see an increase in unemployment, they try to give a stimulus to the economy with the help of the interest rate or with an increase in the amount of money. But when those incentives are considered, the banks use macroeconomic models to see the possible effects of their measures, although there is no perfect model to indicate the real effects. The problem is that in the diversity of models that exist each one shows different magnitudes in the effects of the interventions so that the banks do not know with certainty what can happen in the economy.


Given this uncertainty about the effects of economic policy, some analysts believe that central banks should not intervene so much in the economy to avoid possible unwanted effects. In general terms, central banks should limit themselves to avoiding prolonged recessions, curbing dangerous expansions, and avoiding inflationary pressures. The higher the unemployment or the inflation the measures of the bank should be stronger but neither aspires to a perfect effect since this does not exist.

One of the main reasons why the effects of monetary policy are uncertain is a topic discussed in the article Expectations in the economy. Expectations and their interaction with central bank policies distort the effects of policies, because not only the variables of the present matter but the expectations of the future as well. For a central bank policy to be efficient and have the desired effects their policies must be credible by the agents of the economy to change the expectations of these.

But another problem facing monetary policy apart from the expectations of consumers, investors and other players, is the political interests of the authorities of the countries. Politicians do not always do the best for the economy as they always avoid making difficult decisions and always do what they are represented by votes. Another problem is the alternation in the power of different ideologies that do not allow economic and monetary policies to be lasting over time. All the above is to highlight the limitations of monetary authorities and because despite the development of economic theory it has not been possible to perfect predictions about the effects of monetary policy.

One of the issues that banks should deal with is inflation. Inflation has four costs recognized by economists:

  • An increase in inflation leads to an increase in the nominal interest rate and therefore the cost of opportunity to have money so that people prefer money in the bank and this leads to having to go more often to the bank.
  • Inflation generates fiscal distortions. For example, when a company must pay capital and income taxes if there is a high inflation rate it may end up paying more because of this effect.
  • Inflation variability generates that year after year no one knows exactly what the inflation rate will be affecting certain assets such as bonds.
  • Inflation causes an effect called monetary illusion that causes people to make systematic mistakes because they value different real and nominal purchasing power changes.

But inflation also has positive aspects. The creation of money by banks and which is the cause of inflation is a way in which the state can finance its spending, for example, it is an alternative to borrowing from the public or raise taxes. It is also positive because when an economy is in a recession the central bank can take expansionary measures and thus help the economy. But if the economy has 0 inflation, or it is very low, monetary policy will be hard to implement and therefore it will be difficult to return production to its natural levels by the bank. In many countries, the main objective of central banks is to achieve an inflation rate between a pre-determined range for each bank that is supposed to be good for the economy. In the following graph, you can see the inflation rate of different countries including Venezuela that is having serious problems in its economy.

Inflation, consumer prices

Graph 9. Inflation, consumer prices. Data taken from the World Bank.

Another way aside from the interest rate to control production fluctuations is the fiscal deficit. It is true that the fiscal deficit helps in the negative cycles, but it must also be considered that fiscal deficits have a negative impact on capital accumulation in the long term. For the debt not to advance continuously when there are expansions in the economy it should be intended to have fiscal surpluses to clean up national accounts. Due to the problems generated by an increase in the debt generated by the fiscal deficit, it is important that investors and citizens are monitoring the fiscal deficit of countries as this can end up affecting the growth in the medium and long-term.

As mentioned before the policy plays an important role in the monetary decisions and the course of the economies so that the healthiest thing for the countries would be to limit their interference in the decisions of the Central Bank and other policies aimed at limiting the fiscal deficits because to not lose support a government may be able to borrow beyond what is necessary and healthy by affecting long-term growth where those governments will no longer be.

European Union.

The next part of the article will be based on the monetary integration of Europe and the details of this integration. The decision to adopt a single currency such as the Euro is the most extreme way to set the exchange rate between countries in a region. When the central bank worries about the exchange rate and tries to fix a stable exchange rate there are many problems for the parity to remain so by unifying several countries under a currency these problems are eliminated as losses of reserves, but other problems arise. In the next graphic shows the members current of the European Union.

Top 30 maps and charts that explain the European Union

Graph 10. Buczkowski A. (2017, March 27). Top 30 maps and charts that explain the European Union. Retrieved October 16, 2017, from

The European countries managed to establish a single currency because throughout history they had had some concerns that led them to take this measure. The first factor is the openness of European economies since they are so exposed to trade, so they are also more exposed to fluctuations in the exchange rate than other countries in the world. The greater proportion of exports or imports in national income the economy is more sensitive to changes in the exchange rate. Secondly, Europe has historically great fluctuations that have led to economic crises and conflicts between them. And the last factor determining the monetary union in Europe was the common agricultural market. This market for its operation needed a stable exchange rate so that helped in the decision to unify the currency.

Then introducing the causes of Europe’s monetary union will now discuss how monetary policy is managed. Europe’s monetary policy is managed by the European Central Bank which, together with the central banks of all the Member States of the European Union, constitutes the European system of central banks. This system is independent of other institutions such as national governments. Monetary policy decisions are centralized in the European Central Bank so that European monetary policy is unique, but its application is decentralized in the national central banks who are responsible for carrying out operations of an open market in their countries.

The governing bodies of the European Central Bank are the Governing Council and the Executive Committee. The Governing Council is composed of the six members of the executive committee and the governors of the national central banks of the countries that are part of the eurozone. This body is responsible for monetary policy and sets out the guidelines for its implementation. The council normally meets twice a month on Thursdays. The executive committee implements monetary policy and gives instructions to the national central banks. The governing bodies of the European Central Bank agree on the policy to be implemented by voting and win the decision that has the most votes. The governors of the national central banks have the same weight in the votes regardless of the economic importance of each country.

The basic task of the European Central Bank is to manage the monetary policy of the European Union and the main priority of this policy is the stability of prices. The bank has established that price stability is defined as an inter-annual increase in euro-zone price indices of less than 2% but positive. Due to this, the central bank decides its corrective measures based on the deviations of the expected inflation with respect to the desired path. To achieve the price target, the central bank has two strategies, the first is related to the money supply and consists of announcing the benchmark for the growth of money. The second strategy consists of an economic analysis of different economic indicators such as economic activity, labor costs, financial assets among others and with this analysis are fixed the interest rates.

A major problem facing the central bank when making decisions is the economic fluctuations of each member country of the European Union. The asymmetric economic cycles have their origin in different specializations of each country and that causes asymmetric perturbations since the most developed sectors in each country face different offers and demands. There is evidence that, with the European Union, many regions have reduced the possibility of being affected by asymmetric shocks thanks to economic integration, but this effect has not been seen in all countries.

An important factor that reduced the costs of monetary union is the existence of interregional labor mobility, since if the demand for a product in one country is reduced and the labor force in another increase the labor force can move freely to the country where it has this more developed sector. But despite good labor mobility, some economists argue that Europe is not an optimal monetary union since country governors vote for measures favorable to their respective countries or otherwise the measures end up affecting more a country that is in a recession than a country that is well economically.




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