Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is essentially the manipulation of interest rates. The last two recessionary periods, 2001-2002 and this current period, have shown policy makers the limits of monetary policy.
In the last recessionary period, then Federal Reserve Chairman Alana Greenspan furiously dropped interest rates until the Federal Funds Rate was dropped below one percent to a low of .75%. The current Federal Reserve Chairman, Ben Bernanke, has dropped nearly as much so far to a current level of 1% with most expecting it to go even lower.
The purpose of monetary policy is to lower interest rates so much that it spawns borrowing from lenders like banks to small businesses to consumers. The limits of monetary policy is that if the economy is weak enough no entity, bank, businesses or consumers, want to take on any extra obligations in the form of debt. As such, the Central bank could drop rates all the way to zero (something currently being contemplated) and borrowers will still not bite because the act of borrowing is something that the current economic environment makes all entities averse to.
The recession at the beginning of the decade showed two limitations of monetary policy. Then, the recession began with the popping of the internet bubble which eventually caused three trillion Dollars in paper losses in the equity markets. This was followed by the events of 9/11 which caused one million job losses in the immediate aftermath. Finally, this was combined with the revelations of accounting malfeasance of Enron et al. The continued reduction of interest rates proved useless against this economic malaise until they were combined with tax cuts by the Bush administration. Then, when the tax cuts expanded the economy, the obscenely low interest rates wheels in motion for the current mortgage crisis.
The current crisis is also showing the limits the limits of monetary policy. Currently, there is far too much fear for lenders to borrow themselves and to lend. Furthermore, borrowers and other entities became so leveraged during the boom in between that they are fearful of taking on any new debt.
Fiscal policy is the process by which the government manipulates the economy through tax policy. Unlike monetary policy which attempts to manipulate by getting entities to use other people's money, fiscal policy attempts to manipulate the economy by allowing entities to keep more of their own money. It is one thing for an entity to spend more of their own money, and it is quite another for an entity to borrow more money from someone else to spend. The last two recessionary periods show the limitations of monetary policy.
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