Ineffectiveness of Monetary Policy

The last few decades have been the high water mark of Monetarism. It had become a hallowed axiom of Central Banking and macro-economic policy making that by targetting inflation and maintaining price stability, economic growth could be controlled. When the inflationary pressures rose, raise interest rates, and conversely when it fell, cut the rates. The unprecedented long period of economic growth, with only minor blips, appeared to lend credence to this view. The business cycle appeared to have been tamed.

The Monetarists had long claimed that contrary to the Keynesian contention that monetary policy was impotent during depression-type conditions, the Fed could have, by loosening the monetary base prevented the Great Depression. Newer versions of the monetary theories have even claimed that the Fed caused the Depression. Paul Krugman lays evidence to prove that both the assumptions are wrong.

The original claim is disputed by the evidence that the monetary base rose steeply during the Great Depression. The aggressive monetary loosening by the Fed and bailout of the financial sector by the Treasury during the ongoing sub-prime crisis and its failure to stem the cascade of bad news seriously undermines the claim that monetary expansion can prevent Recessions.

Update 1
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!

Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.

However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!