How Does Monetary Policy Affect a Recession?
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The U.S. Federal Reserve aims to enact a monetary policy that promotes maximum employment, stabilizes prices and provides moderate interest rates.
The primary instrument for achieving these goals is the Fed's control of the money supply. In an overheated economy, where the danger of inflation exists, the Fed may restrict the supply of money. This raises interest rates and slows down the economy by making it more costly for businesses to borrow money for expansion, and for individuals to buy on credit. In a contracting economy, where the danger of a recession exists, the Fed pursues the opposite course. By increasing the money supply. it lowers interest rates, making it easier for businesses and consumers alike to borrow. That in turn encourages increased economic activity.
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Theory vs. Practice
It is agreed by many mainstream economists that monetary policy, as an International Monetary Fund position paper puts it, is "a meaningful policy tool for achieving both inflation and growth objectives." However, the effectiveness of monetary policy in practice is questioned by many economists, some of whom dispute even the underlying theory. This dispute is generally one between economic conservatives and economic liberals.
Liberal economists like Paul Krugman often find the Fed's implementation of monetary policy timid and inadequate. This dissatisfaction with the effectiveness of monetary policy in practice is relatively widespread, a point emphasized by influential Berkeley economists Christina and David Romer in an extensively documented history of Fed monetary policy failures, "The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter ."
conservative economists are equally dismissive of the Fed's success in regulating the economy through monetary policy, for different reasons. A short Wall Street Journal article on the recent attempts of U.S. and European central banks to attempt to revive, then stabilize economies following recessions is that "monetary policy just isn’t very effective."
A Dispute Without a Resolution
There is no magisterial view of this dispute that provides a certain conclusion that monetary policy is effective or ineffective, because any failure can be interpreted as the consequence of an insufficiently robust monetary policy on the one hand, or as the consequence of the very implementation of that policy on the other.
An article published by the conservative Cato Institute, for example, compares the relatively rapid recovery of the economy from the 1981-82 recession with the slower recovery from the 2008-09 recession, and concludes that the difference was that in the earlier recession, the Fed let the economy recover naturally, while in the later recession the Fed pursued an aggressively accommodative policy that ultimately weakened and slowed the recovery.
The Romers' report, on the other hand, looks at the Great Depression that began in 1929 and lasted to 1941 and cite many examples of the Fed's failure to intervene as the primary reason for the Depression's length and depth.
The reality is that in order to know without any doubt if monetary policy is truly effective, you would have to experience the same recessionary period of history twice, once with Fed monetary policy intervention and once without. That, of course, is not an available option.Source: ehow.com