by Merlin Hernandez

The reality of economies is that they are subject to the roller coaster that is the business cycle. The role of a central bank in a recession is really to nudge the economy back on a path to growth and maintain stability of output and prices. In recent times there appears to be a disproportionate expectation that the Federal Reserve will make an economic turnaround happen. But this is beyond the scope of the central bank alone. Moving the expansion curve towards a growth trend is the point at which the effectiveness of combined monetary, fiscal and other necessary measures might be determined.

When the economy is in a slump, the Federal Reserve has several tools at its disposal to influence a turnaround by increasing money supply and controlling inflation. A decrease in the reserve ratio that reduces the percentage of reserves a bank is required to hold against deposits is one way to make more money available for loans to businesses. Another avenue is open money operations (Quantitative Easing) which allows the Fed to purchase financial assets like treasury bills, bonds, and foreign currencies from government, corporations, banks, and other financial institutions allowing them to build cash reserves, loosen lending policies and lower borrowing costs to stimulate business and employment.

Offering low discount rates to commercial banks can also stimulate the economy by signaling to financial markets that they can lend more. Perhaps the least viable option would be printing more money against the same reserves which engenders fear of spiraling inflation. But any large injection of money into the system runs the risk of sustained inflation if the economy does not grow at a rate commensurate with the money supply. It is important that government’s fiscal policy maintains purchasing power through increased government spending to kickstart the stalled economy and sustain fledgling growth. A further fiscal stimulus like tax reduction for the large middle class increases disposable incomes to induce increased demand for goods and services.

Businesses would take advantage of the monetary stimulus to increase output while benefiting from the increased demand facilitated by the right fiscal policy to give traction to the economic recovery. In other words, government’s fiscal policy operates in tandem with the Federal Reserve monetary policy in order to avoid a liquidity trap where there is too much money available for business investment and too little takers because of low demand. While mitigating the potential liquidity trap, keeping interest rates close to the rate of inflation creates a disincentive to hold on to money because of low marginal yield and stumps any threat of deflation. The conditions are thus created for a climate of investment. It is not that the measures used by the Federal Reserve have been ineffective but that a reliance on the central bank to make a recovery happen is to place too great an emphasis on monetary policy alone to smooth business cycles.

Efforts by the Federal Reserve to increase the money supply in order to stimulate the economy in a time of recession have been seen by many economists, including Milton Freidman, as impractical as a principal strategy. Some of the factors that influence the inadequacy of a singular reliance on monetary policy include unstable relationships in the working money supply between monetary aggregates like currency in circulation, demand deposits, savings, and money market shares. The interrelationships among other macroeconomic variables like the velocity of money, exchange rates, credit quality, corporate debt, and international capital flows also make the case for the current integrated fiscal-monetary approach to stimulating growth.

Related Articles on this Blog
• Fiscal Cliff
• Deflation Threat
• October Insights 2012: A monthly eye
• Is the recession over?
• European Unrest

Advertisements