Monetary policy, as well as financial policy, serves as a tool for managing and controlling economic fluctuations such as inflation and recession. These policies are primarily used to influence the overall demand side of the economy. Therefore, it is necessary to assume the preconditions and limitations of using these policies. Neglecting or not paying attention to these assumptions, preconditions, and restrictions can put countries into an economic crisis.
The basic assumption behind all economic theories, which generally examine the relationship between two or more variables, is the stability of other conditions and variables. This assumption practically does not exist. Therefore, relying solely on theories, experts, and economic analysts for analyzing economic issues and providing solutions can lead to errors and misdirection.
The basic premise of contractionary monetary policy in dealing with inflation posits that inflation is primarily caused by an increase in demand relative to supply. Therefore, the remedy involves reducing demand by lowering liquidity and interest rates.
This assumption can be considered very unrealistic for the following reasons:
a) Doesn’t inflation happen due to cost pressures?
b) Doesn’t inflation occur due to the ripple effects from one sector to other sectors of the economy? In the case of sector-specific inflations that occur in any economy and inevitably affect the entire economy, a monetary contraction policy that targets overall demand lacks efficiency.
c) Is the decrease in the value of money solely caused by an increase in the supply of money, and does the demand for money in determining its value not play a role? If so, a contractionary monetary policy is ineffective.
Let’s not forget that money is a commodity whose value is more influenced by demand than by supply. The effects of a decrease in value due to increased supply can be minor and gradual, while the effects of decreased demand can be immediate, severe, and have a negative, self-reinforcing impact on its value.
Often, experts and policymakers equate the interest rate of bank deposits with that of government bonds. They recommend increasing the deposit interest rate to curb inflation. However, this approach can lead to increased deposits and, consequently, a sharp rise in the banks’ ability to create liquidity, which can further fuel inflation.
Even if the bond rate is correctly understood and increased, this policy is only effective if the government refrains from spending the collected financial resources anew; in other words, when there is no budget deficit.
All monetary theories operate under the assumption that the sole medium of domestic trade in an economy is its national currency. If a control system for the circulation of these substitutes doesn’t exist, it can lead to an increased replacement of these goods for money. This can result in a decrease in the value of the currency, trigger inflation, encourage the growth of the underground economy, and diminish governmental oversight and provincial tax revenues.
During periods of acute inflation, when overall demand has declined due to reduced purchasing power among the populace, the implementation of a contractionary monetary policy can exacerbate the recession.
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