What it means
Central banks normally try to steer the economy by changing interest rates and the amount of money in the banking system. Lower rates are meant to encourage borrowing, spending and investment.
The idea works well when firms and households are willing to take on debt. The phrase describes what happens when they are not.
If businesses see poor demand for their products, they will not borrow to expand no matter how cheap credit becomes. If households are worried about their jobs or already carry heavy debts, they save or repay loans rather than spend.
Banks can also be part of the problem. After a financial crisis, banks may hold on to extra cash instead of lending it out, because they are worried about losses and about meeting capital rules.
The central bank can then fill the banking system with money, but the money sits on bank balance sheets rather than flowing into the economy. The comparison with pulling is that policy tightening is more reliable.
When a central bank wants to cool an overheating economy, it can raise rates, and borrowing becomes more expensive almost whatever people's mood. Raising rates restrains spending effectively, while cutting them can only offer the opportunity to spend, not guarantee it.
For business leaders, the idea is a warning not to assume that cheap money automatically means strong demand. A company planning expansion on the basis of low rates should still test whether customers will actually buy.
In such periods, governments sometimes turn to fiscal policy, meaning spending and taxation, to supply the demand that monetary policy cannot. The phrase is often linked to the economic thinking of the 1930s and has been used again after financial crises.
It is a metaphor rather than a technical measurement, and economists disagree on how often it really applies. Some argue that unusual central bank tools can still work even when ordinary rate cuts do not.
In practice
Real-world examples.
Example
A central bank cuts its policy rate to near zero after a recession, yet total bank lending to businesses barely moves. Companies tell surveys they have no plans to expand because customers are not buying. The cheap money is available but nobody wants to use it.
Example
A manufacturer is offered a loan at a very low rate to build a second factory. Its sales forecast shows flat demand for the next three years, so the board declines the loan. The low rate alone was not enough to change the investment decision.
Example
A bank has plenty of surplus cash after a central bank programme of asset purchases. It tightens its lending standards because it fears defaults, and small firms struggle to get loans. Policymakers see the liquidity pile up inside banks rather than reach the real economy.
Case study
Seen in the real world.
Eastmoor is an illustrative, fictional economy that has just come through a banking crisis. Its central bank cut interest rates from 5% to 0.25% over eighteen months and added extra money to the banking system. Officials expected credit to grow and unemployment to fall.
Instead, lending to businesses was almost flat. A fictional manufacturer called Eastmoor Textiles, which was typical of its sector, had spare capacity in its factories and no new orders. Its finance director said that borrowing at 1% was no more attractive than borrowing at 5%, because there was nothing profitable to spend the money on.
The government eventually launched a public building project to create demand directly, and orders began to rise. The illustrative lesson was that when demand is the problem, cheap money alone cannot solve it.
Watch out
Common mistakes.
- Assuming that a cut in interest rates always leads to more borrowing and spending, regardless of confidence and demand.
- Reading the phrase as meaning monetary policy never works, when it works well in many conditions and mainly struggles in deep downturns.
- Planning a business expansion solely on the basis of cheap credit, without confirming that customer demand exists.
Questions
People also ask.
Who first used the phrase?
It is commonly associated with economic debates of the 1930s, but its exact origin is less important than the idea it describes, so treat the attribution cautiously.
What is the usual alternative when monetary policy is not enough?
Governments often use fiscal policy, such as spending on infrastructure or tax changes, to raise demand directly.
Is it the same as a liquidity trap?
They are closely related; a liquidity trap describes the condition where rates are so low that further cuts have little effect, and push on a string is the picture used to explain it.
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