The Shifting Ground Under Monetary Policy

The prosperity of a country's economic system relies on a trade-off between inflation and growth, a trade-off which is orchestrated by a country's central bank which wields the invisible lever of monetary policy. This instrument that shapes the global financial systems, relies on the balance of interest rates, money supply and credit. As our world evolves, so must its policies, due to the reality that every day the financial market becomes ever more complicated. Recently, we have seen President Donald J. Trump (a huge supporter of cryptocurrencies) entering the White House in America. We have seen Cryptocurrencies such as Dogecoin double in price since the election and others are continuing on a strong upward trend. But what does this mean for central banks? Cryptocurrencies challenge the central banks’ traditional control over money supply. This control usually relies on the central banks' ability to regulate the flow of flat currency in the economy by using tools such as interest rates, open market operations and reserve requirements. If more people adopt cryptocurrency, leading to a substantial portion of transactions and wealth shifting to this decentralized currency, the central bank will find it hard to regulate money supply, investment and spending which are all key components of Nominal GDP. For decades, during times of economic hardship, the central bank has been able to lower interest rates, making credit more accessible and saving less desirable due to its small returns. Consequently, causing spending to have a lower opportunity cost. This means consumers gain a higher Marginal Propensity to Consume as well as firms gaining a higher Marginal Propensity to Invest. This accommodation is an effective Expansionary Monetary Policy and the movement of liquidity through the market can lead to more economic growth through mechanisms such as the accelerator phenomenon. However in the context of cryptocurrency this dynamic becomes complicated. Cryptocurrencies such as bitcoin carry a deflationary bias due to their fixed supply (21 million coins), meaning as demand for the coin increases so will its purchasing power. This anticipation of appreciation can lead to increased saving and decreased spending, a dynamic over which central banks would have little or no control over during times of economic crisis. Additionally, due to speculative activity of the coin it can bear harsh price volatility, affecting an economy's ability to plan and further hindering consumer spending as well as firms changing price levels or wages. The economy works off of predictable price changes and a stable and regulated currency and therefore this boom in the cryptocurrency sector due to President Trump's election, if continued to appreciate in value could make it hard for countries to achieve macroeconomic objectives, penultimately leading countries to reassess their approach on market regulation and modern day monetary policies. 

One such country undergoing significant changes in its monetary policy is China. The People's Bank of China (PBoC) is shifting from its historic reliance on quantitative credit targets to a more orthodox, interest-rate focused framework: bringing the country’s policies closer in line with the European Central Bank and the US Federal Reserves. Historically, the PBoC has operated by setting multiple different interest rates and offering unofficial guidelines to banks allowing for targeted economic growth. However, using this way of shaping the economy through monetary policy has led to the economy suffering from overcapacity in certain sectors and excessive credit exposure, particularly in the property market. Whilst it is not unusual and many countries do operate on multiple different interest rates, the lack of a single, dominant policy rate complicates the transmission of monetary Policy within a society. This fragmentation in the economy can result in inconsistent lending practices across banks, triggering what is often referred to as ‘race to the bottom’ where banks compete and in doing so continuously lower their interest rates to attract more borrowers. This then encourages firms to take on more debt to invest in capital, often beyond what is necessary for current demand. If too many companies invest in capital in periods of expansion this can lead to overcapacity within an economy. Whilst idle capacity can fuel growth if used effectively, monetary policies designed to increase demend take time to work. This can create lags, like the cobweb cycle, which can destabilise markets. Unstable market mechanisms foster the loss of ‘animal spirits’ within firms. 

Driven by the decline in credit demand following a prolonged downturn in China’s housing market, the PBoC has had to rethink its approach to monetary policy, acknowledging that its previous methods of steering credit expansion are not sustainable. PBoC has announced a larger focus on market-driven investment and consumer spending which will push China to focus on innovation, greener technologies and productive investment rather than simply expanding the size of the credit market. This will change the fundamental ways China's monetary policy tries to achieve macroeconomic objectives such as GDP and inflation, through narrowing their interest rate corridor they will be able to influence China's economic environment in a more precise and controlled manner. 

Core principles of monetary policies dictate that interest rates are a key determiner of the cost of borrowing, therefore central banks can use them to control aggregate demand and the overall inflation rate in the economy. This can be seen through the use of several economic models. When analysing these effects through the IS-LM model which illustrates equilibrium in both the goods market (investment equals savings) and the money market (money demand equals money supply); we can see that a decrease in interest rates shifts the IS curve to the right. This signals an increase in aggregate demand in the economy as the cost of borrowing has decreased, firms are able to invest in more capital and consumers are able to take on more debt at a lower cost. Conversely, when interest rates are increased the IS curve shifts leftwards signaling a contraction in aggregate demand and economic output, which helps to stabilize inflation by curbing excessive demand in the economy. Aligning with this model, the Phillips Curve highlights a current trade-off between inflation and unemployment; as the IS curve shifts right due to low interest rates, aggregate demand increases as mentioned previously, therefore firms will have to employ higher amounts of human capital in order for the market to find a new equilibrium, this in accordance with the Phillips Curve will mean lower unemployment and proves as an explanation of how low interest rates cause inflation within an economy. 

Whilst monetary policy is a powerful tool to influence macroeconomic outcomes such as GDP and inflation, its prolonged and aggressive use can cause undesirable outcomes. One such phenomenon is the emergence of ‘Zombie Firms’ within an economic system. This occurs when low interest rates set by the central bank- which are otherwise an effective tool for stimulating growth and mitigating downturns- create conditions that allow unproductive firms to survive. These firms, which would otherwise fail in a high interest environment due to their inability to service their debt due to low profits, keep functioning- tying up resources in inefficient uses. Debts are essentially ‘bringing spending forwards in time’, meaning people build up debts to do spending today that they couldn't otherwise afford (these debts could build up in headwinds). As this happens in an economy, zombie companies manage to receive loans due to the fact that the low interest rates make the financial business of the banks, insurance companies and pension funds unprofitable, meaning they in turn take ever more risky bets on outlandish loans that they otherwise wouldn't have made in order to keep their margins up. As the Eurozone and China enter a period of forecasted economic instability due to the tariffs Donald Trump is planning to set, countries will have to consider this whilst adjusting their monetary policies. As the countries adjust their interest rates to recover from the forecasted economic recession, excessive reliance on rate cuts could inadvertently lead to the proliferation of zombie businesses. For an economy facing the struggles of an economic downturn, this could cause great damage and can be a key contributing factor to the ‘stagflation’ that Şebnem Kalemi-Özcan (a professor at Brown University who also sits on the New York Fed’s advisory panel) forecasts after the tariffs come into action (Storbeck, O 2025). Stagflation is the coexistence of high inflation and low economic growth- an obvious failure when assessing a country's ability to meet its main macroeconomic targets. As there are more of these firms in the market, the market faces near-full employment which causes inflation. Growth will be low due to the stagnation of productivity through the inefficient use of resources and crowding out investment which is caused by the occupying of capital and market space by these firms deterring FDI in new, more dynamic businesses. 

Whilst interest rate manipulation is arguably the primary lever of monetary policy, central banks also rely on open market operations such as the buying and selling of securities. By adjusting liquidity in the financial system through measures such as quantitative easing, banks also successfully manage to control key macroeconomic objectives whilst staying clear of risks associated with excessive monetary stimulus such as asset bubbles, zombie firms and inflationary pressures. Initially, when central banks like the Bank of England or the European Central Bank implement quantitative easing by trading bonds, the increase in demand for these securities pushes up their prices- the demand increases due to the near-zero risk of government bonds in an unstable economy, which is signaled by quantitative easing measures. This causes bond yields to fall due to the inverse relationship between bond yields and prices. The immediate effect of lower bond yields is a reduction in borrowing costs across an economy. This is because government bonds represent a benchmark for interest rates on corporate bonds and loans due to the fact that government bonds represent the risk-free rate of return investors will receive from buying bonds and therefore corporate bonds must offer higher yields to compensate for the additional risk. Therefore, firms can lower the yield they offer on their bonds whilst remaining equally as competitive as before allowing them to access cheaper financing options to fund investment and expansion. This dynamic can be observed through a tighter ‘credit spread’, where the gap between risk-free government bonds and corporate bond yields narrows. As a result of this, investment spending increases which, in theory, should lead to higher employment levels as companies expand their operations and hire more workers. However, complexity arises in the way that firms utilize this cheap credit- whilst some invest on increasing their productive capacity, others engage in stock buybacks or speculative asset purchases. This fuels asset price inflation without greatly improving real economic activity, as evident from post-quantitative easing index growth trends for the FTSE 100 and S&P 500. The rising stock markets create a wealth effect within the economy further encouraging consumer spending, thus boosting aggregate demand and contributing to nominal GDP growth. However, this effect is unevenly distributed benefitting asset owners more than wage earners thereby exacerbating income inequality within the economy. Additionally, an economy can also suffer through the prolonged use of quantitative easing, although the initial spillover into the real economy supports job use, as observed in UK and Eurozone employment statistics, too much money circulating in the economy can lead to inflationary pressures. These conditions particularly hurt the economy if they are paired with supply-side constraints, as seen in the post-pandemic period when UK inflation surpassed 10% in 2022. To counteract this rising inflation, banks have to reverse their accommodative stance by raising interest rates, which, whilst necessary to prevent runaway inflation, also increases debt servicing costs for businesses and households. As a result households suffer from reduced disposable income, slowing investment and increasing the risk of unemployment. This is illustrated by the Phillips Curve trade-off, initial short-term conditions are shown where efforts to control inflation through monetary tightening come at the expense of job losses, particularly in interest-rate sensitive sectors such as real estate and construction. Additionally, the Long Run Phillips Curve is shown by the change back to the mean before quantitative easing measures as the labour market again slackens after its initial tightening. Another long-term risk is that quantitative easing inflates financial market bubbles- if central banks decide to reverse quantitative easing through quantitative tightening by selling off bonds, bond prices fall, yields rise and borrowing costs increase which can lead to sharp contractions in economic activity which can cause recessions as seen in past post quantitative easing reactions. 

Ultimately, the effectiveness of monetary policy in influencing employment and economic growth within the economy is non-linear and its success is subjective to economic stability and the amount of control a central bank has over its currency. Its implementation is shaped through the timing and scale of quantitative easing, structural labour market conditions and central currency control, making central bank decision-making an inherently complex balancing act between stimulating growth and preventing inflationary overheating.