Monetary Policy Lags & Pitfalls

Economics: IB Diploma, topic 2.6.4

Pitfalls of Monetary Policy

In the real world, effective monetary policy faces a number of significant hurdles:

Monetary policy affects the economy only after a time lag that is typically long and of variable length.
Remember, monetary policy involves a chain of events: the central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates.
When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars.

As a result of this chain of events, monetary policy has little effect in the immediate future. Instead, its primary effects are felt perhaps one to three years in the future.
The reality of long and variable time lags does not mean that a central bank should refuse to make decisions.
It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.

If banks decide to hold excess reserves, monetary policy cannot force them to lend.
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.
When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well.

When are the primary effects of a change in monetary policy felt in the economy?
During what stage of the economic cycle are banks most likely to hold excess reserves, over and above the legal requirement?