Monetary Policy and Inflation (9) Banker Fraility

Central bankers who think they need to manage the speed of the economy face two major problems. The first is that the economy does not have a speedometer. The best statistical measures of economic activity are not sufficiently precise and are available to late to accurately measure the speed of the economy. So most of the time, the central bankers do not know whether the economy is growing too fast or too slow. They will often take the wrong action.

The other problem is that controlling the interest rate is a very blunt instrument. When using interest rates to slow the economy, central bankers hurt all businesses, not just those which are lest efficient. Higher interest rates prevent efficient businesses from expanding and may cause some to shift overseas. Exporters are often hurt by the consequential rise in the currency.

On the other hand, reducing interest rates to speed up the economy encourages all businesses to expand, when it would be better if only the more efficient ones grew. Worse still, the low interest rates can cause distortions in the economy, by encouraging speculation in fashionable assets.