Is monetary policy becoming less effective?

This hints that the transmission mechanism of monetary policy might have broken down. When ultra-low interest rates appear to be ineffective in restoring confidence and spending, this is known as the liquidity trap. For the exam you need to explain how a reduction in policy interest rates can stimulate household and business sector demand and also (through the exchange rate) providing a stimulus to export s. But we do not live in normal times! There are grounds for thinking that – in the short term at least – the impact of monetary policy may have been reduced. Here are some reasons:

Is monetary policy becoming less effective?

1. The continued unwillingness of commercial banks to lend – most banks are de-leveraging i.e. cutting the size of their loan books and being more selective about whom to lend to.
2. Banks have been reluctant to pass base rate cuts onto consumers. Indeed the average cost of a bank overdraft or a credit card loan has increased over the last two years.
3. There is little incentive to lend when interest rates are at low levels
4. Low consumer confidence / expectations means that people are not prepared to commit to major purchases such as a new kitchen – recession has made people risk averse as unemployment rises
5. There remains a huge level of household debt that will need to be paid off including £200bn on credit cards
6. Falling asset prices – average house prices fell sharply during 2008-09 and this has created a problem of negative equity for many thousands of property owners. Negative equity occurs when the market value of a house falls below the outstanding mortgage debt.
7. Lower interest rates have helped bring the value of sterling down – but the world economy has shrunk (global trade is down 10% in 2009) and this has hurt our export sector.
8. Lower interest rates reduce the spending power of millions of people who do not have mortgages but have built up savings in bank and building society accounts.