Rational Expectations Can Limit Monetary Policy
The government’s capacity to stimulate the economy through increase in the monetary supply is limited by rational expectations and fears that the people have about inflation. Specifically, investors understand that the increases in monetary supply can cause inflation. This means that when the government increases the monetary supply to reduce nominal interest rates, they have to do it with moderation to avoid causing fear of inflation that can compensate the stimulating effect of the raise in monetary supply
Expectation about Inflation Has an Effect on Interest Rates
The subjacent quandary is that the Federal Reserve only has partial control over the interest rates. In truth, it controls the supply but does not control the monetary demand. This is a bit of a problem, because if the people believe that an increase in the monetary supply is going to bring about inflation, the monetary demand increases because people consider they are going to need more money to buy goods at higher prices.
So while the increase in the monetary supply tends to go reduce the interest rates, an increase in the monetary demand caused by fear of inflation tends to diminish investment, any increase of similar things due to fear of inflation goes against the stimulus that is trying to be applied to the economy by increasing the monetary supply.
Keeping Low Expectations of Inflation So the Monetary Policy Works Well
Starting from the seventies, most countries have made sure to be very careful when it comes to using the monetary policy. This is due to that in the decade of 1970 economists were able to learn that if people believed that an increase in the monetary supply was going to cause inflation that increase could end up producing mainly inflation, instead of a stimulus.
There is also what is known as stagflation, which is a combination of economic inflation and industrial recession, during which consumer prices rise but business output falls. This is often accompanied by rising unemployment at businesses cut back. An example of stagflation was in the United States during the 1970s, when rapidly rising oil prices pushed consumer prices up sharply but caused businesses to cut back production.
The experience of stagflation during the seventies taught the Federal Reserve that the monetary policy works better if people believe that the central banks are not going to cause inflation. Therefore, now the Federal Reserve only increases the monetary supply in a moderate way whey they want to stimulate the economy. These increases end up being much more effective that great increases, because they do not arouse inflationary fears.
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