Monetary Policy can Fail in Following Situations:
- Recession. Banks are legally required to hold a minimum level
of reserves, but no rule prohibits them from holding additional
excess reserves above the legally mandated limit. For example,
during a recession banks may be hesitant to lend, because they fear
that when the economy is contracting, a high proportion of loan
applicants become less likely to repay their loans.While banks want
to keep excess reserves then expansionary monetary policy will not
work well. Central Bank cannot force the individual banks to make
loans.As banks are concerned about declining economy they do not
want to take risk by giving loans. Similarly people and business
owners will not like to take loans during recession as they fear
the payment of interests due to declining economic activity. The
result is that during an especially deep recession, an expansionary
monetary policy may have little effect on either the price level or
the real GDP.
- Deflation Deflation is just the opposite of inflation. It means
that money has more purchasing power. Deflation can make it
difficult for monetary policy to handle recession.If the
nominal interest rate is 6% and the rate of
inflation is 3%, then the borrower is effectively paying a 3% real
interest rate. If the nominal interest rate is 7% and there is
deflation of 2%, then the real interest rate is actually 9%. In
this way, an unexpected deflation raises the real interest payments
for borrowers. It can lead to a situation where an unexpectedly
high number of loans are not repaid, and banks find that their net
worth is decreasing or negative. When banks are suffering losses,
they become less able and eager to make new loans. Aggregate demand
declines, which can lead to recession. If central bank uses
expansionary monetary policy to meet deflation. Suppose deflation
rate is 4% and central bank wants to reduce interest rate to zero,
then real interest rate will be 4%. Since nominal interest rate
cannot be negative, so expansionary monetary policy cannot reduce
the real interest rate further.
- Changes in Velocity
Money Supply * Velocity = Nominal
GDP
Nominal GDP = GDP Deflator * Real
GDP
So, We can Say
Money Supply * Velocity = Nominal GDP
= Price Level * Real GDP
- If velocity remains constant then percentage change in money
supply will lead to same change in GDP,.this change could happen
through an increase in inflation, or an increase in real GDP, or
some combination of the two. If velocity is changing over time but
in a constant and predictable way, then changes in the money supply
will continue to have a predictable effect on nominal GDP. If
velocity changes unpredictably over time, however, then the effect
of changes in the money supply on nominal GDP becomes
unpredictable.So, we can say that it is difficult to predict
velocity. It can change in unpredictable ways.
- Lags. Lags pose another problem for
monetary policy.The policy may be designed for a particular period
or economic situation but when it is implemented the economic
condition may change thus, making monetary policy ineffective.