Question

Which of the following is a limitation of monetary policy:

1. The central bank cold lose control over domestic money supply and interest rates, which can become more volatile  

2. The foreign currency can come under speculative attacks and lose significant value, which can eventually lead to a full-blown crisis.

3. The central bank could maintain too much control over domestic money supply and interest rates, which can become more volatile exchange rate targeting.

Answer 1

Monetary Policy

Monetary Policy is a policy of money-related actions. It is a policy of central bank. It focus on money supply and rate of interest. Its purpose is to regulate growth, liquidity, consumption and inflation. It deals with altering rate of interests, managing of foreign exchange rates, trading the bonds of government, varying the bank reserves etc. This policy influences the prices, employment and output. Monetary policy can be contractionary or expansionary.

Analyzing option (1)

From the above reasons, it is clear that option (1) is not the correct answer. It is saying that central bank lose its control over supply of money and interest rates due to monetary policy. As per above mentioned statements, it says that central bank gain control over supply of money and interest rates due to monetary policy, not losing the control. Hence, that statement is invalid and thus option (1) is incorrect. Thus, it is not a limitation of monetary policy.

Analyzing option (2)

According to the monetary policy, central bank of a nation may sometimes buy back their own local currency from the foreign exchange for keeping a stable rate of exchange. They make utilize their reserves in foreign exchanges for this buy back. But, whenever there is a situation occurs, where the investors, whether foreign or domestic, realize that the central bank does not have adequate foreign reserves, those investors will start speculative attack. It means they start to target the domestic currency of that nation. In such a situation, these investors will start exhausting the foreign currency of central bank by selling local currency of that nation to the central bank for a fixed rate of exchange. As this process continues, central bank's foreign currency will be completely consumed by the investors. Then, central bank will not be able to buy back the local currency for a fixed rate of exchange. This will lead to the accumulation of foreign currency in the nation and a rapid diminishing of local currency. Major targets of speculative attacks will be nations with low war chests.

Hence, option(2), ie; The foreign currency can come under speculative attacks and lose significant value, which can eventually lead to a full-blown crisis, can be said as a limitation to monetary policy.

Analyzing option (3)

Option(3) says that central bank could maintain too much control over domestic money supply and interest rates. It is true. But it is a positive side by the way, and can be said as the primary objective of making a monetary policy by the central bank. Hence, option(3) is an advantage of monetary policy.

CONCLUSION

Limitation of monetary policy is option (2) The foreign currency can come under speculative attacks and lose significant value, which can eventually lead to a full-blown crisis.