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EC 100 Quantitative Easing

EC 100 Quantitative Easing. Quantitative Easing. This week we talk about how the financial crisis lead to a new way of performing monetary policy. The reason being: the traditional tools to conduct monetary policy were less effective.

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EC 100 Quantitative Easing

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  1. EC 100Quantitative Easing

  2. Quantitative Easing • This week we talk about how the financial crisis lead to a new way of performing monetary policy. • The reason being: the traditional tools to conduct monetary policy were less effective.

  3. Old(er) monetary policy(not what Danny means by “traditional” / “conventional” monetary policy – see next slide) Buying and selling of government bonds. To increase the money supply: • Central bank buys (short term) government bonds from banks and gives them “cash” in return. • This increases the amount of “base” money in the economy. • A certain fraction (1-d) of the base money can be lent out by the banks. They are required to hold a fraction in their reserves. (We have a “fractional reserve” banking system). • This lending gives rise to the money supply multiplier. • Money supply curve shifts to the right and interest rates fall….investment increases so Y increases.

  4. “Traditional” UK monetary policy • Since independence in 1997, the Bank of England has followed a policy of “inflation targeting”. • Targets 2% inflation rate over the medium term. • Wants to achieve “price stability”. Under this policy, inflation should be • Low • Stable • Widely known • Price stability enables long-term planning by investors and savers and so should increase investment. • 2% avoids (i) deflation, (ii) excessive inflation, (iii) unexpected inflation.

  5. “Traditional” UK monetary policy • The Bank achieved the 2% target by setting the interest rate that it offers on short-term loans to private financial institutions (such as banks). This is known as the Bank Rate. • Lowering the interest rate boosts economic activity by shifting the LM curve to the right. Investment increases, asset prices (e.g. house prices) increase, and in an open economy the ER depreciates which boosts exports.

  6. “Traditional” UK monetary policy • Hence the Bank of England targetted inflation by altering interest rates. If inflation fell below 2%, reduce the Bank Rate; if inflation rises above 2%, increase the Bank Rate. • Conventional monetary policy sought to achieve price stability through setting the Bank Rate.

  7. Quantitative Easing • How is this related to Quantitative Easing? • Q.E. is used when inflation is below target. It is also used to achieve price stability. • When interest rates are very low (zero lower bound), conventional monetary policy is very weak.

  8. Quantitative Easing • Hence the Central Bank resorts to large-scale asset purchasesto get liquidity (money) into the economy. • Asset purchases from private financial institutions (among others). So: Both traditional monetary policy and QE attempt to achieve price stability. Traditional approach relies on setting the Bank Rate, QE relies on asset purchases from non-bank private financial institutions.

  9. Why did we reach the Zero Lower Bound? A key reason could be a breakdown of lending by banks. • There was huge uncertainty in the global economy following the Financial Crisis. Banks wanted to hold reserves instead of lending. • So the traditional money multiplier was weak: printing money had less effect on the overall money supply. • The Central Bank resorted to direct lending to financial institutions (i.e. quantitative easing). This circumvents the banking sector, breaking the traditional money multipler. • This implies that the Bank of England Balance Sheet has to grow disproportionally in order to have the same effect as traditional monetary policy.

  10. Question 2 • How does QE alter both the size and composition of the central bank's balance sheets? Why might central banks seek this? • As we saw above, the Central Bank is now lending directly to private financial institutions. Circumvents the traditional money multiplier. • The Central Bank therefore has to create a lot more money to achieve the same money supply effects. • This implies that the balance sheet will grow significantly.

  11. Question 2 • How does QE alter both the size and composition of the central bank's balance sheets? Why might central banks seek this? • The composition of the Balance Sheet will also change. • The Central Bank now has lots of long term assets from private financial institutions (such as insurance companies and pension funds). • Government bond purchases also shifted from short-term to long-term. “Operation Twist” in the US.

  12. Question 2 • Why Q.E.? • Two reasons discussed above: • Interest rates may have reached the zero lower bound. Hence traditional monetary policy becomes ineffective at boosting investment. • The banking sector may be performing badly. Banks are not lending which dramatically reduces the money multipler effect. Hence Central Bank decides to lend to companies directly.

  13. Problem 3 • What are viewed to be significant risks in the practice of QE? How are these specific to QE? Which of these would be shared by all expansionary monetary policies? • Remember: monetary policy only affects P in the long-run (no effect on Qf). Hence in the long-run, expansionary monetary policy will only increase prices. • Many of the risks involved in QE are therefore shared by traditional monetary policy.

  14. Asset prices increase, and interest returns on asset falls. This is a major problem for pension funds - over £300bn debt of UK pension funds. (Shared, exaggerated under QE). • Maastricht Treaty: Central Banks should not finance public deficits. Can lead to hyper-inflation. (Shared). • Boosting asset prices benefits the wealthy, increasing inequality. (mainly QE problem). • Increased uncertainty – when will it stop? (mainly QE problem). • International spillover – cheap liquidity heads to emerging markets where financial systems underdeveloped. (Shared, exaggerated under QE). • Competitive devaluation – “beggar thy neighbour” policy. (Shared).

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