Policy Approach

Weaknesses

As with the strengths associated with each policy, you will also need to analyse the weaknesses in two ways. You might be asked to examine the overall weaknesses of the policy, but you could equally be asked to assess the policy in relation to one particular goal.

There are several weaknesses associated with the implementation of monetary policy.

Impact Lag: Perhaps the most troublesome of weaknesses, it has been noted by many economic commentators that there can be a significant impact lag associated with the implementation of monetary policy. In general, it is safe to assume that there is a 12-18 month lag after any change in interest rates before it will have an impact on the economy. There are several reasons for this. Assume that interest rates are to be increased. At this stage some consumers and businesses will already have organized a new loan. As such, the money that they borrow will come through at the higher rate. At some point after receiving the money they will spend it – we will assume this is to build a house. It is likely that this money will be spent over an extended period, as a house can not be built overnight. As such, all of the people working on the house will be receiving an income (and therefore continuing to spend) while the house is being built. As such, any increase in interest rates may take some time to flow through to the economy. On the other hand, a decrease in rates can take even longer. This is because people will only spend when they are confident, and falling interest rates will only slowly affect the general confidence level in the economy.
Effectiveness: From the previous discussion, it is apparent that monetary policy is more effective when employed to slow the economy than it is to stimulate it. This can be seen at many points in recent history. During the global financial crisis the RBA was aware that in order to have the desired impact they would need to be very aggressive when cutting the cash rate. As a result, a series of reductions totalling 425 basis points was put in place. On the other hand, as the strength of the economy became apparent the RBA was unwilling to increase the cash rate in the same way; a series of smaller increases (25 basis points each) was implemented.
Blunt instrument: Monetary policy affects all participants in the economy. When interest rates are increased, any business or consumer with a loan will have to pay a higher rate of interest in order to finance that loan. As such, monetary policy is ineffective when attempting to control just one part of the economy. This was apparent in the late 1980’s when interest rates were increased partly in the hope of reducing spending on imported goods and services – the impact on domestic production was even more dramatic.

To relate these weaknesses to one of the economic goals of the government, we need to examine a time in which our economic goals were not being achieved. During 2008 the rate of inflation increased to 4.5%. This figure is well above the target band of 2% to 3%, and so the RBA was justifiably concerned. However, the high figure for inflation was not uniform across the Australian economy; some sectors were performing well (especially mining and construction), while others were suffering (for example, tourism). Increasing the cash rate at that time would have been ineffective, because of the impact lag. The RBA had tried to pre-empt this problem, but had obviously not been aggressive enough in their approach. When earlier increases in the cash rate did begin to have an effect, they created problems for those sectors that were already struggling. This suggests the blunt nature of monetary policy.

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