- Inflation targeting
- Inflation targeting is a rule that requires a central bank to focus primarily on keeping inflation low.
- Countercyclical policy
- Countercyclical policy moves in the opposite direction to the business cycle, loosening in downturns and tightening in upswings.
Pitfalls for monetary policy
Can you name the three pitfalls that can blunt monetary policy?
Each one weakens the link between a decision by the central bank and what happens to spending.
A change in interest rates takes a long and uncertain time to work through lending, spending and prices, with its main effects perhaps one to three years later.
Can you think of an example?
The Monetary Policy Committee raises Bank Rate to curb inflation, but by the time spending slows the economy is already cooling, and the rise deepens the downturn.
Excess reserves are reserves banks choose to hold rather than lend, so extra reserves from loose policy may never reach borrowers.
Can you think of an example?
In a recession Bank Rate is cut, but banks fear borrowers will not repay and keep the extra reserves, while firms with falling sales do not want loans anyway.
The zero lower bound is the floor that stops a central bank cutting its nominal interest rate much below zero, however deep the recession.
Can you think of an example?
Bank Rate is already close to zero and prices are falling, so the real interest rate stays positive and the usual rate cut is no longer available.