Governments may find both expansionary and contractionary monetary policy to control aggregate demand not as effective as they had hoped, due to the economic agents’ expectations and the difficulty in timely applications of the policy. A policy undertaken too late or where consumers’ and firms’ expectations work against the policy, is likely not to achieve the desired outcome.

Whereas it is possible for governments to use a hard and prolonged contractionary monetary policy to reduce lending and suppress aggregate demand, achieving the aims of an expansionary monetary policy can prove to be more challenging. For example, if interest rates are lowered to pull the economy out of a recession, the policy may not be effective if consumers and firms do not borrow to spend and invest when they expect the recession to persist. The central bank policy rate could be reduced to close to zero, but it could still fail to stimulate the economy. With low interest rates and high levels of liquidity, borrowing and lending may remain low and the economy may get caught in a ‘liquidity trap’. One way that governments try to instil confidence in consumers and firms to encourage spending is by providing forward guidance that interest rates are likely to remain low for a prolonged period of time.

A problem with raising or lowering interest rates is that it may cause economic agents to become fearful about other potential changes in interest rates and the pace at which they will be made, this increased policy and economic uncertainty can then lead to a loss of consumer and business confidence affecting consumption expenditure and investment. The raising of interest rates will also tend, over time, to raise the cost of servicing the national debt which will possibly lead economic agents to save more and invest less in anticipation of higher future taxes. In this manner raising interest rates may have a greater impact on future economic growth.

In an open economy context raising interest rates will tend to lead the domestic currency to appreciate which can have an adverse effect on export volumes and raise import volumes over time leading to a deterioration of the trade and current accounts of the balance of payments. While if interest rates are lowered then this depreciates the currency which can exacerbate an inflation problem.

A significant problem facing governments is that if there is an independent central bank then it may be reluctant to reduce interest rates in times of recession if it is towards the upper levels of its inflation target.