During an economic recession, unemployment rises while incomes, business investment and consumer spending fall. Monetary policy aims to shorten recessions by encouraging consumer spending and investment. Monetary policy actions can help shorten recessions or reduce their impacts, but economic conditions may limit their impact. In addition, it takes time for policy decisions to be felt throughout the economy at large.
Government usually responds to an economic recession through stimulative fiscal policy, expansionary monetary policy or a combination of the two. Stimulative fiscal policy involves higher government spending in an attempt to stimulate the economy. Expansionary monetary policy consists of actions by central banks, such as the U.S. Federal Reserve, to expand the money supply to encourage more consumer spending and business lending.
Expansionary monetary policy actions to battle a recession include the purchase of government bonds by central banks, reducing banks' reserve requirements, and lowering short-term interest rates.
The purchase of government bonds by central banks injects more money into the economy. Lower reserve requirements give banks more money to lend because they are required to hold fewer reserves against deposits. Increased lending by banks stimulates business investment and expansion. A reduction in short-term interest rates also encourages more investment by reducing the cost of borrowing. Lowering short-term interest rates also reduces the rates on home mortgages, lowering mortgage payments for homeowners, giving them additional disposable income.
Although expansionary monetary policy has the ability to reduce the length and severity of an economic recession, there is no guarantee it can do so. Lower interest rates, for example, may not stimulate consumer spending if consumers have little confidence in the economy. They are unlikely to increase their spending if they believe their jobs are at risk because of a sluggish economy. Businesses may be reluctant to invest in new facilities and equipment for expanded operations if the economy is in a recession. Finally, banks may be unwilling to increase their lending during a recession.
Another concern about the ability of monetary policy to impact a recession is that the effects of policy decisions, such as a cut in interest rates, will not be immediately felt. It can take more than a year for the effects of lower interest rates to be felt.
During the 1991 and 2001 recessions, Federal Reserve policymakers repeatedly cut short-term interest rates to stimulate investment and consumer spending. It took time, however, for the effects to be felt. In 2001, for example, a series of Fed cuts reduced short-term interest rates to near zero. However, consumer uncertainty about the future, resulting from the 9/11 terrorist attacks, coupled with a distrust of corporate accounting practices resulting from the collapse of Enron, blunted the effects of Fed efforts to expand the money supply.