We learned about the monetary policy, the transmission mechanism and how monetary policy can be use to control inflation and bring price stability. However, monetary policies have several limitations and may not always work as intended. One reason is that the monetary policy is not the only thing affecting output, employment and prices. There are many other factors affecting the aggregate demand and supply and therefore the economic positions of households and firms. Below are a few examples explaining how monetary policy decisions can go wrong.
Assume that the government is reducing money supply with the intention of reducing inflation. If people believe that, they will expect lower future inflation. However, the long-term rates carry a premium for inflation. For this reason, the long-term rates can actually fall, stimulating the economy, even though the central banks increased short-term rates, which was expected to slow down economy. Similarly, an increase in money supply can increase the long-term rates, even as the short-term rates fall.
Another example is a liquidity trap. According to New York Fed, a liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. In this case, many argue, increasing money in circulation has no effect on either output or prices. The liquidity trap is originally a Keynesian idea and was contrasted with the quantity theory of money, which maintains that prices and output are, roughly speaking, proportional to the money supply. According to the Keynesian theory, money supply has its effects on prices and output through the nominal interest rate. Increasing money supply reduces the interest rate through a money demand equation. However, this theory is defied in case of a liquidity trap.
The third example is the case of deflation, which is much more difficult to control compared to inflation. If a country is facing deflation, the best a central bank can do is to reduce its policy rate to zero. It cannot stimulate the economy beyond this.
Another example is a situation where the banks decrease their lending even if the money supply is increasing, they have excess reserves and short-term rates are falling. This could be because of prevailing business conditions or other factors, such as recent losses suffered by them.
In reality, monetary policy makers do not have up-to-date information on the state of the economy and prices. Although policymakers will be able to offset the effects of demand shocks on the economy, it takes time for shocks to be fully recognized. And it can take even longer time to counter these shocks. Along with this we have to deal with the uncertainty about how the economy will respond to an expansionary and contractionary policy. All of this can easily set the economy and prices on the wrong path.