In 1997 the central bank of Japan used an easy money policy to reduce real interest rates to zero. Even with "interest-free" loans available most consumers and businesses did not borrow and spend more. Japan’s severe recession continued, and the Japanese government turned to expansionary fiscal policy to stimulate spending. (The Japanese economy began to expand slowly in 1999 but stalled again in 2000.) The Japanese circumstance illustrates the possible asymmetry of monetary policy, which economists have likened to "pulling versus pushing on a string." A string may be effective at pulling something back to a desirable spot, but it is ineffective at pushing it toward a desired location. So it is with monetary policy, say some economists. Monetary policy can readily pull the aggregate demand curve to the left, reducing demand-pull inflation. There is no limit on how much a central bank can restrict a nation’s money supply and hike interest rates. Eventually, a sufficiently tight money policy will reduce aggregate demand and inflation. But during severe recession, participants in the economy may be highly pessimistic about the future. If so, an easy money policy may not be able to push the aggregate demand curve to the right, increasing real GDP. The central bank can produce excess reserves in the banking system by reducing the reserve ratio, lowering the discount rate, and purchasing government securities. But commercial banks may not be able to find willing borrowers for those excess reserves, no matter how low interest rates fall. Instead of borrowing and spending, consumers and businesses may be more intent on reducing debt and increasing saving in preparation for expected worse times ahead. If so, monetary policy will be ineffective. Using it under those circumstances will be much like pushing on a string.

Photograph courtesy of: (c)Corbis # DAS0021;