Monetary policy tools are used by currency boards, central banks, or even governments to control currency supplies. Consumer access to cash, along with the interest rates charged by lending institutions, create economic foundations for businesses to build upon. The tools used to regulate those base needs dictate how much stability is found in the financial markets. There are numerous ways for monetary policy tools to be used as a benefit to society. They maintain a balance of value with currency exchanges, stabilize economies, and can even address debt or unemployment issues.
The Federal Reserve is tasked with the implementation of monetary policy tools that promote expansion or limit recession at the national level. Based on the rates they set, local banks and credit unions create offers for their customers which encourage an expansion of borrowing. People then purchase homes and vehicles, or use their credit cards, to generate economic activities.
The advantages and disadvantages of monetary policy tools look at how these artificial structures compare to what a natural free-market system would dictate for each person.
List of the Advantages of Monetary Policy Tools
1. They encourage higher levels of economic activity.
Monetary policy tools encourage consumer activities based on the current status of the economy. When a stimulus is necessary to keep growth happening, then banks can lower their interest rates on lending products to encourage additional spending. Lower interest rates create price reductions, which help keep spending at a consistent level. People have more incentive to buy low, even if their wages are under the national median, which means their spending gives strength to the local community.
2. They encourage a stable global economy.
Most countries operate with currencies which are traded in value against others. There is no “gold standard” in use by the most influential financial nations in the world today. Thanks to monetary policy tools, there is greater consistency in the financial markets because there are known factors of scarcity. That’s why a government which decides to print more money will devalue their currency. It also creates opportunities to purchase bonds, increase reserves, or invest in the debt of other nations to generate multiple revenue lines.
3. They promote additional transparency.
Monetary policy tools create predictable results when used as intended. Everyone involved in the financial sector understands what happens when movement occurs in either direction – or if the status quo is maintained instead. These design of the tools forces those who use them to do so in ways that are understood by the general public, allowing organizations and consumers to make decisions about their future now instead of waiting for the tools to create a measurable effect.
4. They promote lower inflation rates.
One of the most significant advantages that monetary policy tools offer is price stability. When consumers know how much their preferred goods or services cost, then they are more likely to initiate a transaction. That process keeps pricing structures stable because the value of the money used is also consistent. These tools make it possible to keep the value of money close to what it tends to be. Between 2009-2018, the inflation rate in the United States was under 10%. That means $1 in 2009 was worth $1.09 in 2018, maintaining the wealth earned by households.
5. They create financial independence from government policies.
Monetary policy tools are kept separate from centralized governments, implemented by a central bank or similar institution instead. The government might try to influence these tools by passing targeted legislation against them, but it cannot control them outright. By keeping the economic decisions separate from the political decisions, there is a reduction of risk for the average person that the government will impact their vote, life, or choices by limiting the value of their overall income.
6. They are implemented with relative ease.
When a central agency indicates that it will use a monetary policy tool in specific ways, then the market shifts automatically to account for the announced changes. Results are often produced well before the effect of the tools begin to occur. That allows for rapid results in some sectors, allowing the government and agencies involved to find tangible evidence that the tool used will create meaningful outcomes.
7. They can boost exports.
When the money supply increases at a national level, or interest rates are lowered deeply compared to the global market, then the currency in question becomes devalued. Weaker currencies sometimes benefit from a worldwide perspective because exports receive a boost thanks to purchases from those in stronger economies. Foreigners find that the products are less expensive, so they buy more of them.
List of the Disadvantages of Monetary Policy Tools
1. They do not guarantee economic growth.
The implementation of monetary policy tools does not guarantee results. People and businesses have free will. They can choose to initiate more spending when rates are lowered, or they might choose to hold onto their cash. Consumers don’t take out loans because the interest rates are down all the time. 100% of households don’t buy or refinance their home. There will always be outliers in every economy which respond in unpredictable ways. If enough entities do this, then the results of the monetary policy tools could be different than what was expected.
2. They take time to begin working.
The United States operates on budget estimates which account for 10 years of activity. Some countries can evaluate changes in half that time, while others use cycles that last for 20-40 years instead. Because currencies are not based on the scarcity of precious metals at this time, the tools must change the overall market to initiate economic shifts instead. Some changes take several years to start creating positive results. There can still be negative experiences in the initial days of a tool being implemented too.
3. They always create winners and losers.
Monetary policy tools try to give everyone the same chance at success. The reality of any financial market, however, is that any shift in policy will create economic winners and losers. These tools try to limit the damage to the people who struggle under the changes made while enhancing the benefits of those who see currency gains.
4. They create a risk of hyperinflation.
Small levels of inflation within an economy are not a bad thing. They encourage investments, allow workers to expect a higher wage, and stimulate growth at all levels of society. Having all items cost a little more over time can slow growth when necessary. If the interest rates are set too low, then artificially low rates happen. That creates speculative bubbles where prices increase too quickly, often to levels which create barriers to access for the average person.
Venezuela experienced devastating hyperinflation in 2018 to the tune of 1.29 million percent. The new sovereign bolivar recently traded at 500 for a single U.S. Dollar, with the value lowering for it each day. That means workers cannot essential basic items. The cost of a banana in Venezuela today is what a house cost just a decade ago.
5. They create technical limitations.
The lowest an interest rate can go under current economic structures is 0%. If the central agency sets rates at this level, then there are limits to what monetary policy tools can do to continue limiting inflation or stimulating economic growth. Prolonged low interest rates also create a liquidity trap, creating a high rate of savings which renders the policies and tools ineffective. They affect bondholder behaviors, consumer fear, and a lack of overall economic activity.
6. They can hurt imports.
When the monetary policy tools reduce the value of the national currency, then fewer imports occur. That happens because international purchases become more expensive for consumers using the currency in question. This effect was seen in earnest when the U.S. Dollar was worth less than a Canadian dollar from 2010 to 2013. Instead of U.S. consumers going over the border to purchase cheaper Canadian goods, the reverse happened. Canadians came to the United States to purchase cheaper American goods.
7. They do not offer localized supports or value.
Monetary policy tools are only useful from a general sense. They affect an entire country with the outcomes they promote. There is no way for them to generate a local stimulus effect. If a community struggles with unemployment, they might need more stimulus to counter the issue. The current design of monetary policy tools doesn’t allow this to happen. The tools are unable to be directed at specific problems, boost individual industries, or apply to regions within the national footprint.
8. They can slow production.
Economies are fueled by production. When more of it becomes available, then the chances for growth increase. If fewer activities occur, then production levels slow, and it could be several years before they can restore themselves to previous levels. The in-ground swimming pool industry encountered this effect during the 2007-2009 recession years, with total U.S. installations dropping 70%. The industry has still not reached the installation rates seen in the 1990s yet because of how the monetary policy tools were used before the global recession took place.
The advantages and disadvantages of monetary policy tools promote economic stability, which then encourages growth. There aren’t guarantees with any tools like this, however, because individuals are unpredictable. People can choose to do the opposite of what the tool anticipates, creating unexpected outcomes which are sometimes damaging to society. There are those who benefit and those who do not, but the goal of the tools is the same: to help the most people possible with what they do.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.