In the midst of a troubled economy, staunch advocates of tight fiscal policy have no hesitation with cutting social services, reducing military spending or slashing salaries as means of maintaining a balanced budget. Others take the opposite approach and advocate stimulating the economy by loosening the monetary policy. Examples of such policies include raising the debt ceiling and introducing liquidity into the economy through low interest rates and quantitative easing programs. A loose monetary policy has a number of effects.
Unemployment
The chairman of the often uses monetary policies as a way to influence the unemployment rate. For instance, Ben Bernanke's April 2011 press conference revealed his belief that introducing inflation by keeping interest rates low is a tradeoff that can help lower the unemployment rate. In this case, low interest rates provide an incentive for corporations to borrow more money and hire workers. Such rates also give consumers easier access to credit by which they can purchase goods and services. Nonetheless, low interest rates encourage taking on debt. This is counter to the principles of adhering to a strict monetary policy.
Inflation
Inflation is a natural effect of loosening monetary policies. In the case of quantitative easing, the Federal Reserve increases the money supply by buying assets. Lowering interest rates also increases the money supply by encouraging borrowing, which in turn increases the number of issued loans. When the money supply increases, the value of the dollar weakens thereby requiring more of them to purchase goods and services. Inflation deters consumers from saving money because of inflation's erosive effects on the dollar's purchasing power.
Economic Growth
Loosening the monetary policy may improve economic growth if companies and individuals are willing to take on debt. Economic stimulus was effective in catalyzing the economy into full employment during WWII and after the Great Depression. However, if the market is hyper risk-averse on account of a poor economic outlook injecting the economy with liquidity does little to boost the economy. As explained by John B. Taylor in the book, "Principles of Economics," this problem occurred shortly after the financial crisis in 2008. In fact, the U.S. experienced a liquidity trap, or, a situation where interest rates held at near zero percent provided no boost to lending. This in turn compelled Ben Bernanke to engage in two rounds of quantitative easing.
Consumer Spending
Consumers sometimes respond to a loose monetary policy by spending more disposable income. However, this is usually in response to having a sense of job security based on positive employment indicators and a robust stock market. Indeed, consumer spending is psychological. Thus, loose monetary policies partly work based on people's mere beliefs that they will improve economic conditions.
Tags: interest rates, monetary policy, loose monetary, monetary policies, money supply, quantitative easing, Federal Reserve