Top-Rated Free Essay
Preview

Purpose and Effectiveness of the Expansionary Policy on Output, Unemployment, Interest rates, and Prices in the Short and Medium Run

Good Essays
1038 Words
Grammar
Grammar
Plagiarism
Plagiarism
Writing
Writing
Score
Score
Purpose and Effectiveness of the Expansionary Policy on Output, Unemployment, Interest rates, and Prices in the Short and Medium Run
Central Banks around the world have been carrying out expansionary policy (quantitative easing) through open market operations since the start of the financial crises.

Explain the purpose of this policy and discuss potential risks associated with it. Describe the impact on output, unemployment, interest rates and prices in the short and medium run. How effective do you expect this policy to be and what factors does its efficacy depend on?

With the emergence of recent financial crisis, economies across the globe have been experiencing quite rough times and faced many difficulties, as well as downturns. Many countries faced the progressively increasing rate of unemployment, big declines in the share of the consumer’s wealth with a subsequent drop of the demand for goods and services. In an urgent necessity of improvement and recovery, governments were designing and implementing various combinations of fiscal and monetary policies, according to the situation on particular markets. Many of the Central Bank’s carried the expansionary policies (or so called quantitative easing) in order to speed up the revitalization of the financial market and speed up the economic growth. The quantitative easing is usually performed via one of the basic and very common monetary tool, - open market operations. In case of the expansionary monetary policy, it means that central banks e.g. Bank of England (UK) or The Federal Reserve (USA) are buying bonds and government securities with the purpose to increase the supply of money in the financial system and the economy. Such purchases of bonds are injecting money into the economy and stimulate its growth. However, as in any other economic tool there are cost and benefits for such policy. In further analysis there will be discussed and outlined the aspects of the purpose of the policy, efficiency dynamics and possible costs and risk of chosen economic policy.

Quantitative easing is often used in order to supply banks with an extra liquidity and increase their capacity to lend money to the firms and businesses, which in return boosts the investment in the economy and as a consequence it shifts the aggregate demand. Because there is more money available to the banks, the cost of borrowing i.e. the interest rate decreases, which also means that investors can take an advantage of newly emerged opportunity of getting the same or greater returns at a lower cost. In other terms, such conditions encourage an increase in investors’ confidence, which is clearly a positive feature. In theory, in the short run such policy should push the economy out of the financial recession by rightward shift of the aggregate output and a fall of the unemployment rate (as partly shown further below on the IS-LM and AS-AD models). On these two graphs the principle logic behind the quantitative easing is shown. In the first case, monetary expansion generates a lower interest rate, which encourages an increase of output due to the rise of the investment. Consequently on the next graph it is illustrated that the increased investment initiates an upward shift of the aggregate demand curve and this explains the rise of aggregate output in the short run.

However in reality monetary policy faces the wide spectrum of influences, which are determined by particular market’s features. Firstly, policy’s efficacy depends on the degree of responsiveness of the investment to changes in interest rate; and secondly the efficiency and result of the policy will be affected by the scale of that decrease of the interest rate caused by money supply expansion. In real economy, firms can follow the domino effect of the “investment depression”, as the unenthusiastic spirit spreads among the investors very quickly and with a confident persuasion. Therefore, in such situations firms are usually not responding to the fall of the interest rate as they are driven by a mass fear of “investment fiasco”; which is exactly what was happening in Europe and United States on the brink of the recent crisis. When the expectations of the future returns are pessimistic and the economy is in an unstable position, firms typically do not make investments, even when they can borrow at the lower interest rates.
Furthermore, especially during the depression conditions the monetary policy can fail to be effective due to the liquidity trap (already observed during the Great Depression (USA), Lost Decade (Japan 90s) and very recent Fed’s actions in 2010). Liquidity trap can be observed when the prevailing short-term nominal interest rates are very low or close to zero, so people tend to assume that the interest rates will rise soon, thus they switch from bonds to savings(because of the inverse correlation with the interest rates) . Therefore, central banks are not capable of “accommodating sufficiently large deflationary shocks by interest rate cuts” (Gauti B. Eggertsson, 2008) and expansionary monetary policy is quite ineffective in such situation.

In the medium run, quantitative easing usually has a risk of resulting in a permanent rise of the price levels and rapidly accelerating rate of inflation in the future, which in turn will have to be adjusted at some point by decreasing the money supply back. Inflation can be a tricky, sometimes hardly controlled outcome of particular policy, as it increases rapidly with the expectations which are naturally based on the previous inflation rate. For this reason economy can fall into trap where the higher inflation expectations will in fact adjust the genuine inflation rate. The impact of the expansionary monetary policy on output and unemployment in medium run depends whether the given economy is operating at the natural level of output or below it, hence the analysis should be committed on a particular case(economy, country) in order to examine these effects.

Reference:

Blanchard, O (2009), 5th Edition. Macroeconomics. London: Prentice Hall.

Gauti B. Eggertsson(2008), Second Edition, Liquidity Trap, The New Palgrave Dictionary of Economics. http://www.newyorkfed.org/research/economists/eggertsson/palgrave.pdf (accessed on 2nd December 2011)

Paul Krugman, 1999, Thinking about the liquidity trap, unknown publisher. http://web.mit.edu/krugman/www/trioshrt.html (accessed on 2nd December, 2011)

Dr. Fidel Perez Sebastian (2011), Lecture slides and notes made during the lectures.
Dr. Ija Trapeznikova (2010), Lecture slides, materials received at seminars and notes made during the lectures.

You May Also Find These Documents Helpful

  • Good Essays

    Federal Reserve

    • 716 Words
    • 3 Pages

    It is to be expected that an economy will rise and fall. To protect it from falling to far the government created the Federal Reserve System. According to socialstudieshelp.com, “The Federal Reserve System's main responsibility is to safeguard the proper functioning of our money system.” This paper will discuss the role of the Federal Reserve, the goals and tools of the Federal Reserve. It will also discuss monetary policy and fiscal policy, how they work, why they are used, the difference between the two, and the appropriate time to use each one.…

    • 716 Words
    • 3 Pages
    Good Essays
  • Satisfactory Essays

    In an effort to move the economy out of a recession, the federal government would engage in expansionary economic policies. Describe the actions the government would take in conducting expansionary fiscal policy and expansionary monetary policy.…

    • 652 Words
    • 4 Pages
    Satisfactory Essays
  • Good Essays

    Next, we will look at expansionary monetary policy tools the Federal Reserve System occupy to pull the economy out of a recessionary gap. The main policy tool the Fed utilizes is buying of government securities(bonds) on the open market to expand…

    • 639 Words
    • 3 Pages
    Good Essays
  • Good Essays

    All these lead to expansionary monetary policy. I disagree with Ms. Lopes’ opinion that The Fed should sell bonds, raise reserves, and leave interest rates. To the contrary, purchasing bonds on an open market will increases the amount of money in circulation in the economy. When the Fed increases…

    • 393 Words
    • 2 Pages
    Good Essays
  • Good Essays

    Federal Reserve Bank

    • 329 Words
    • 2 Pages

    As a result of these new tools the Federal Reserve is able to extend credit and purchasing securities. This “credit easing” uses the balance sheet by changing both the absolute level of the balance sheet as well as the types of assets it contains (Federal Reserve of Cleveland, 2011). They use the Fed’s authority to extend credit or purchase and can supplement traditional monetary policy tools by changing the mix of assets it holds (Federal Reserve of Cleveland, 2011). This is different from the approach used by the Bank of Japan to generate policy actions, these tools focus on the mix of assets (Federal Reserve of Cleveland, 2011).…

    • 329 Words
    • 2 Pages
    Good Essays
  • Better Essays

    1. (15 points) The accommodative policies of the Federal Reserve System, the European Central Bank, and the Bank of Japan involve the purchase of fixed-income securities to infuse liquidity into their respective economies for the purpose of stimulating economic activity. Using the “money line-spending line” diagram and aggregate demand and supply curves, depict a situation in which monetary accommodation will not produce the intended outcome. Apart from the graphical analysis, what is a reason to doubt that the policies will work as intended?…

    • 1829 Words
    • 8 Pages
    Better Essays
  • Good Essays

    The Monetary Policy Simulation demonstrates the impact of monetary policy upon the U.S. economy. Acting as the Chairman of the Federal Reserve, you are charged with directing the nation's economy for ten years. There are three economic indicators that are monitored to evaluate the economy. These indicators are the Real Gross Domestic Product (GDP), the Inflation Rate and the Unemployment Rate. The tools that are at your disposal include the ability to adjust the Federal Funds Rate (FFR), the Discount Rate (DR) and the Required Reserve Ratio (RRR). In addition, you have control of the Open Market Operation (OMO) through the buying and selling of bonds, t-bills and other federal instruments. As you move through the ten-year period, the economy is affected by an Asian import threat, an increase in the minimum wage, an increase in Defense spending, a European economic crisis, a tax cut, and a trade embargo. Th ability to control the money supply to counteract these issues is the key…

    • 593 Words
    • 3 Pages
    Good Essays
  • Powerful Essays

    Nursing Shortage

    • 1638 Words
    • 7 Pages

    scenario, some economic output of the issue, what policies were made in past and some…

    • 1638 Words
    • 7 Pages
    Powerful Essays
  • Better Essays

    In economic terms, a recession is defined as a general slowdown in economic activity. In an effort to move the economy out of a recession, the government would implement expansionary economic policies. One action the government would take would include conducting expansionary fiscal policy. The other action taken would be conducting expansionary monetary policy. Both of these actions would have an effect on such things as money supply, interest rates, spending, aggregate demand, GDP, and employment.…

    • 1540 Words
    • 7 Pages
    Better Essays
  • Good Essays

    Fiscal policy is the process the government uses to determine the appropriate level of taxes and spending necessary to deal with recessions, inflation, and unemployment. This is accomplished by the government deliberately making changes "…in either government spending or taxes to stimulate or slow down the economy" (Colander, 2004, p. 583). The methods used to accomplish such are identified as expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy can be used to bring an economy out of a recession, and contractionary fiscal policy can be used to reduce real output to fight inflation. The way these tools are used, as well as the possible need for their use in the current economy, will be discussed in further detail in the following pages.…

    • 1020 Words
    • 5 Pages
    Good Essays
  • Better Essays

    Firstly, expansionary monetary policy is a timely, quick and effective way to help improve and provide immediate relief to the economy during a recession. In 2008, the FED made multiple public announcements, accompanied by swift decisions and explained that expansionary monetary policy can help to prevent an adverse feedback loop. This occurs when a recession creates uncertainty about asset values (valuation risk). As a result, firms are not confident enough in their financial position to engage in spending and investing activities. Such a situation could lead to greater uncertainty and cause a further deterioration in macroeconomic activity and this continues. This mechanism is also referred to as the financial “accelerator” by economists (Ben Bernanke, Mark Gertler, and Simon Gilchrist, 1999). If a timely, decisive and flexible policy is implemented by…

    • 1534 Words
    • 7 Pages
    Better Essays
  • Good Essays

    The Federal Reserve took drastic measures beginning in late 2007 with the establishment of new credit facilities to provide liquidity to financial institutions. During the recession, the Fed quickly lowered interest rates to stimulate the economy and increase the cash flow. I agree with the strategy used by the Fed regarding the monetary policy during the…

    • 885 Words
    • 4 Pages
    Good Essays
  • Good Essays

    In the short run, lower real interest rates in the US also tend to reduce the foreign exchange value of the dollar, which lowers the prices of the exports sold abroad and raises the prices of foreign produced goods. Expansionary monetary policy also raises aggregate spending on US produced goods and services by improving the balance of trade. A monetary policy that constantly attempts to keep short-term real rates low can lead to high inflation and higher nominal interest rates to protect the purchasing power of the funds due to them. This is the reason that economic activity can not keep expanding beyond its potential level. Initially, the low real interest rates will cause business and households to increase their borrowing demands, and…

    • 232 Words
    • 1 Page
    Good Essays
  • Satisfactory Essays

    Suggest and justify elements of fiscal and monetary policies that would help achieve its objectives…

    • 269 Words
    • 1 Page
    Satisfactory Essays
  • Good Essays

    Expansionary monetary policy (EMP) is a policy through which the central bank increases the money supply in an effort to boost economic activity in a country. The short and long-run effects of EMP are important in analyzing its effects on income inequality. EMP affects individuals differentially as individuals earn income from different sources.…

    • 767 Words
    • 4 Pages
    Good Essays