BEA220 – Intermediate Macroeconomics
Lecturer: Dr Jui Saprungrueng
The aim of this report is to identify the meaning of “Quantitative Easing” and why it was adopted by central banks during the recent financial crisis. It will also try to identify what central banks were trying to achieve by using Quantitative Easing and how they planned to achieve that. The report will look at other financial crisis’ where Quantitative Easing was adopted and whether it was successful. Finally it will look at the risk involved with Quantitative Easing.
What is it?
The definition of Quantitative Easing varies among countries however the principals behind it are very much the same. When referring to the Bank of England’s monetary policy, economist Joe Ganley describes Quantitative Easing as the purchasing of financial assets by the reserve bank through the creation of new money. The money is created electronically and placed into accounts held by commercial banks. The injection of money is used when interest rates are close to zero in an attempted to increase spending and therefore increase inflation to the target rate of 2-3% (Ganley 2010). Japanese economists (Fujiki, Okina, & Shiratsuka) define Quantitative Easing as the purchasing of long-term government bonds and the implementation of a policy to increases bank reserves held with the central bank (Konstantinos & Werner 2010).The bank of Canada describes it as the purchase by a central bank of financial assets through the creation of central bank reserves. The price of purchased assets increase and the yield on the asset falls, resulting in an expansion of reserves available to commercial banks. This encourages banks to increase their supply of credit to businesses and households (Bank of Canada 2009).
Why did Central Banks use it during Global Financial Crisis?
The reason central banks used Quantitative Easing throughout the Global Financial Crisis (GFC) was to close the gap between nominal demand and potential supply in the economy. Demand had fallen steeply as global demand had contracted and domestic consumers tightened their belts (Ellis 2009). The usual monetary response to deal with a recessionary gap in the economy is too lower interest rates. This is what the Monetary Policy Committee from the Bank of England decided to implement. In a five month period they dropped the official bank rate from 5 per cent to 0.5 per cent in order to keep inflation from falling below the target rate of 2 per cent. The Monetary Policy Committee decided that the interest rate could not be lower than 0.5 per cent (Ganley 2010). C
The Philips Curve in figure 1 shows the decrease in inflation due to the economy entering an economic crisis. A recessionary gap was created as short run out (Y) is below potential output (0) leading to a decrease in the level of inflation from point A to point B. The IS-MP curve (figure 2) shows the economy in steady state at point A. When there is the economic downturn consumers decrease investment and increase saving due to consumer uncertainty, moving the IS curve to IS’ creating a recessionary gap at point B. The central bank implements monetary policy by reducing the nominal interest rate to 0.5%. This moves the MP curve down to MP’. However at point C short run output is still below potential output and interest rates cannot be reduced anymore. There are many reasons why central banks can not reduce interest rates to zero. One of them being that it can seriously damage the money market infrastructure. This is because if banks can borrow money from the central bank at no cost, then there is no incentive for banks to borrow or lend from one another. This poses a problem when the central bank wants to raise interest rate as it...
References: Konstantinos, V & Werner, A 2010, New Evidence on the Effectiveness of ‘Quantitative Easing’ in Japan, Centre for Banking, Finance and Sustainable Development, 2010.
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