Quantitative Easing
Table of Contents Abstract Introduction • Stabilization policy
• Fiscal policy
• Open market operations
• Quantitative Easing
• Monetary policy
Quantitative Easing • Definition
• Overview
• Risks
• Motivation of this research ( why did you choice this topic)
• Objectives of the research
• Feasibility ( time and sources, any limitations)
History of Quantitative Easing Examples of the quantitative easing like (Japan and USA) Comparison of USA and Japan Conclusion References
Abstract
This paper discusses policy tools used by government in stabilizing the economic environment of a country. Apart from the common stabilization, monetary and fiscal monetary, the paper introduces the concept of quantitative easing which is gaining popularity in management of modern economies. It defines, gives an overview as well as a comprehensive explanation of the mechanics involved in implementing the policy. In addition, it gives insight on the historical perspective is highlighted with special reference to The Japanese and US cases. The paper ends with a summary conclusion tying all the concerns and expectations of the policy.
INTRODUCTION Economic development among societies is the single most important goal pursued by people across the world. Every individual, community, society and nation strives to achieve higher levels of development in order to avail higher and better living standards to the masses. The three most important parties in this development process are households, the firms and the government. Better economic performance is their common goal. Households strive to achieve better living standards; firms strive to achieve better profits while the government supports the achievement of these two goals. This is in a capitalist economy. In a bid to achieve these goals, the need to develop policies to harness the strengths of each of these economic units emerges. There are numerous policies targeting different aspects of the economy. In this paper, focus is on how governments apply policies in the management of the financial sector in order to achieve growth and development. The main policies of focus here include: the stabilization policy, fiscal policy, open market operations, quantitative easing and monetary policy. Special emphasis will be laid on quantitative easing where an in-depth analysis will be conducted on its effectiveness as well as its historical successes or failure in nations where it has been tried.
Stabilization Policy Before the 1930’s a majority of economists never thought that the government was in any position to offer viable solutions to problems facing the economy. Indeed they were very skeptical of any attempts by government or central banks to intervene as they believed that this would tamper with the self regulatory mechanisms in the market leading to irreparable instabilities. This long held view was upset by the great depression of the 1930’s. The sudden collapse of the US and consequently global economy showed signs indicating that the economy itself is inherently unstable. This inherent instability caused the collapse of the stock markets resulting in one of the most agonizing economic moments of history. Classical economists came to appreciate the cyclical nature of economic growth. Just like in many other aspects of life, the economy is characterized by periods of depressions and accelerated growth or a boom. Periods of depression are characterized by deflationary pressures; slowed productivity hence increased unemployment rates. This is definitely a concern for the authorities as it leads to diminished standard of living among the people threatening social stability (Willem, 2010, par4). In times of economic boom, the economy is characterized by high inflationary pressures, high productivity hence high employment rates. Despite the fact that these are desirable attributes, when they happen in extreme measures, the economy undergoes what economists call “overheating”. This has negative effects on the long term health of the economy (Stabilization Policy, 2010, par5). Consequently, economists agree that interventions by government are important in a bid to ensure a smoother trend of economic growth. Stabilization policy was accepted as it was clear that only the government had the ability to salvage the economy. Stabilization policy includes strategies put in place by government and the central financial institutions with the aim of keeping growth levels, prices and levels of unemployment in moderate levels to avoid the ills associated with both extremes i.e. the depression and the boom. Stabilization policies are aimed at reducing cases of erratic fluctuations in prices, output and unemployment. In addition to stabilizing, the policies are employed when economies are facing some specified shocks like the market crash and faults in sovereign debt. Under such circumstance, stabilization policies often come direct from the politic all class such as direct legislation and reforms in securities. It could also emanate from international players like the World Bank. Clearly, the aim is to apply all necessary measures to ensure that the economy adopts the smoothest trend possible. In most cases, the stabilization policy entails a combination of fiscal and monetary policies as well as additional policies which are specific to the problem. Applying stabilization policies has its advantages and disadvantages. In models of imperfect competition, economists argue that most stabilization policies introduce new rigidities in cases where the market is imperfect making the economy even less efficient. However in cases where the markets are operating in perfect competition, then the rigidities introduced by the attempts to respond to economic phenomena do not considerably affect the efficiency of the economy (Stabilization Policy, 2010, par6).
Fiscal Policy Fiscal policy is a tool used by governments in regulating the level of demand in the economy and hence regulates growth patterns. A recession presents a need for the government to explore ways of jumpstarting the economy. As mentioned above, a recession is characterized by low levels of production. A simple way of accelerating the production rate is through heightened demand. Bearing in mind the fact that the households are facing reduced incomes, the government has to come in and deploy money for various activities such as infrastructural development. This way, the government can accelerate growth rate or in the case of a boom, cut down the rate of growth. Consequently, fiscal policy basically entails expenditure by the government in goods and services but also the way in which the expenditure is financed. In reverse, fiscal policy can also be applied through reducing or increasing taxation or tax rates. This is because, the same way increased government spending seeks to raise the amount of money in the hands of the firms and consequently the households, a reduction in the tax rate enables firms and households to retain a bigger proportion of their incomes hence boost aggregate demand (CliffsNotes.com, par2). There are two main ways in which financing of government expenditure is done. First is using tax money raised from the general public. Secondly, the government may finance through borrowing. Ultimately, a rise or decline in level of government spending has direct impact on important economic variables such as aggregate demand mentioned above and equally important, resource allocation patterns as well as income distribution. In this case then the policy can be used to achieve socio-political goals in an economy (CliffsNotes.com, par5). The budget is the single most important vehicle with which fiscal policy is implemented. It basically stipulates both the sources of government funds as well as the way in which the funds are allocated to the different areas of priority to government. This being the case the two main ways in which the fiscal policy can be applied is through the expansion or contraction of government spending. Expansionary fiscal policy entails expanding government spending with the aim of lifting the economy from a sluggish growth rate. Contractionary policy is applied when the economy is experiencing a boom as a way of slowing it down. As concerns the funding mechanisms, the budget could be in three different stances. They include a budget deficit, a budget surplus and a balanced budget. A budget deficit stance means that the government spends more than it can raise through taxation hence requiring additional funds from borrowing. The most common borrowing instruments used by government include treasury bills and bonds which in most cases are called government papers. Borrowing locally or internationally has different repercussions for the economy. A balanced budget implies that the government spends as much as it is able to rise from taxation. This is a case of living within means. A budget surplus occurs when the government is raising more money through taxation than it is able to spend. The goal for most government is to achieve a balanced budget however in many cases the need to finance development projects pushes countries into perpetual budget deficits. Keynesian economists are strong proponents of the application of fiscal policies in reducing the cyclical nature of economic growth however classical economists express some reservation to this route. They express two main defects with the policy. First, when an expansionary fiscal policy is applied to boost aggregate demand but it turns out that the funds applied are raised through domestic borrowing, then there is a likelihood of “the crowding out effect”. This is a situation where the gains made through the expansionary policy are offset by the resultant high interest rates. High interest rates result when the government borrows money locally hence diverting funds which would have been borrowed by firms for investments. Reduction in the supply of loanable funds definitely leads to a rise in interest rates. High interest rates raises the cost of financing for investors hence less investors are willing and able to take up loans to scale up production activities. Consequently, the positive effects of expanding the government spending to boost aggregate demand is weighed down by the limitation in access to funding for the firms (CliffsNotes.com, par8). The second defect cited by classical economists is the fact expansionary fiscal policies decreases the net exports of a country which according to them is an important component of a country’s GDP. They argue that government borrowing increases interest rates in an economy hence attracting foreign investors who are in search of better returns. These foreign investors must first convert their funds from the foreign to local currency leading to a rise in demand for the country’s currency. An increase in demand for currency leads to a currency appreciation. The principles of international trade imply that an appreciation in local currency means that the cost of local goods in the foreign markets rises making them less affordable. The effect is a decrease in the level of exports. Again, the appreciation implies that foreign goods cost less in the domestic markets hence import levels rise. The overall effect then is a fall in the level of net exports for the country. In recent times, expansionary fiscal policies have been employed across the globe in the backdrop of one of the greatest recession in modern economies. The US leads with the injection of about 600 billion dollars in to the economy to jumpstart demand in different sectors of the economy. Other countries in Europe, Asia and Africa followed suite and about two years later, it appears that the global economy is coming out of the recession.
Open Market Operations (OMO) In an attempt to either control the liquidity levels in an economy as well as interest rates, central banks have a few options to consider. Top on those options is the open market operations. Open market operations basically involve the sale and purchase of government securities openly to interested investors. Government securities are issued in exchange of specific amounts of money and mature after a specified period when the money is refunded with some earnings. The two main government securities are treasury bills and treasury bonds (Akhtar, 1997, par5). When the liquidity levels in the economy is high, interest rates are low consequently firms are able to borrow more for production activities. However, if the economy is already experiencing high growth rates, the central bank may opt to ‘mop up’ excess liquidity from circulation hence increasing interest rates which in turn reduce the ability of investors to borrow and consequently, the growth rate is managed. ‘Mopping up’ in this case means selling government securities to investors and holding on to the money realized. On the other hand when the liquidity levels are low interest rates are likely to be high as demand for money is higher that supply. The central bank may opt to boost the economy through reduction in interest rates as a result of increased liquidity. This would entail buying back the government securities hence releasing money (Acerbic, and Obstfeld, 2005, p115). OMOs are highly effective in managing liquidity in the short run and medium term. Treasury bills last for periods as short as three weeks while bonds last much longer but usually do not exceed three years. In addition to managing interest rates, OMOs also help manage inflation as well as exchange rates. Inflation rates are high when liquidity is high as the ease with which money is available means that people may be willing to pay more for goods and services hence a rise in prices. When the excess liquidity is mopped up, there is less money available for spending hence limiting the ability of firms to hike prices. Effects on exchange rates occur due to the inflows and outflow of funds prompted by changes in interest rates as described earlier under fiscal policy. Notably, OMOs are part of monetary policy described below.
Quantitative Easing Quantitative easing is an extreme form of monetary policy. A shall be discussed under the sub topic ‘monetary policies’ below, central banks have great influence on interest rates in the economy and they often use this influence to regulate the growth rates. For example in times of low growth interest rates can be lowered to stimulate investments. Likewise, in times of extremely high growth, interest rates can be increased to slow down the ability of producers to scale-up their production. However, most developing countries are better placed to apply this tactic especially in periods of slowed growth because in these economies, interest rates are considerably high. In the developed world, the situation is different. Due to the high availability of capital, interest rates are at a very low level. Consequently, the flexibility is limited. Once the interest rate hits zero, it cannot be further reduced despite the fact that the economy may not yet be out of the recession. This problem has been addressed by developed countries like the US through the concept of quantitative easing. Quantitative easing is a rather unconventional tool whose popularity appears to be improving by the day. It is mainly seen as attempts by the federal or central bank to increase liquidity in the market but at the same time ensure that interest rates remain low in the long run. Usually, when central banks inject money into the economy, two variables are expected to change. First inflation rate is expected to increase and secondly, the interest rates fall in the short run. According to economists, when inflation rates are too high, the economy suffers and in many cases, the gains made by the prevalence of low interest rate in accelerating investments are lost. Consequently, as a reactive measure, the central bank has to act in order to tame inflationary pressures. However, any attempts to tame the inflation level cause interest rates to rise. Therefore, the final result in the long-run is that interest rates will have to raise yet again hence lowered investment. This then makes this kind of policy approach unsustainable and irregular. Quantitative easing comes in to introduce some level of consistency and macroeconomic stability required to give investors some confidence on the long term viability of investing in the economy.
Monetary Policy Just like fiscal policy, monetary policies are used by governments to regulate economic growth as well as achieve macro-economic stability in the economy. However, unlike the fiscal policy which is largely influenced by the political agenda, implementation of monetary policy is largely controlled by central banks which have the capacity to safely apply it. Just like the word monetary suggests, the policy targets the monetary aspect of the economy. This is by controlling amounts of supply of money in the economy. The linkages between the monetary and the real economy give life to the effectiveness of the policy in influencing the real economy. The most important target variables for this policy are the interest rates, exchange rates and inflation. Just like the fiscal policy, there are expansionary and contractionary monetary policies. Expansionary monetary policies entail efforts put in increasing the supply of money in the economy while contractionary policies seek to reduce the supply of money in the economy. Reducing or increasing money supply in the economy works through the normal laws of demand and supply to vary the level of interest rate, which at this moment cost of accessing money. Increased supply implies reduced interest rates while reduced supply results in increased interest rates. For inflation, higher supply implies higher inflation while tightened supply cubs inflation (Galindev, 2010, par3). There are three critical tools applied by central banks in implementation of monetary policy. They include Open Market Operations (OMO); discount window operations and Reserve requirements. OMO as described above involves the buying or selling of securities in the market and mainly to commercial financial institutions. The aim is to control the reserves held by commercial banks and hence determine their ability to issues loans to firms. When the central bank sells securities to the financial institutions, it drives down their reserves upon which they base their ability to issue loans. When the commercial bank’s ability to issue loans is curtailed, the money stock in the economy adjusts downwards to the levels desired. When the central bank buys back securities from these commercial institutions, it releases money and drives up the ability their ability to lend. This builds on the money stock in the economy. The second tool used by central banks is the Discount Window Operations. One of the most important roles of the central bank is “the lender of last resort’. Commercial banks borrow money among themselves to alter their lending capacities at different time periods. They charge each other some interest rate lower than the market rates. On the same breadth, the central bank which is endowed with significantly high state resources has an obligation to lend to commercial banks. Just then same way banks charge each other some interest rate, central banks charge commercial banks at a rate referred to as the ‘Bank rate”. This bank rate is an important tool for controlling the ability of banks to borrow from the central bank (Monetary policy, 2010, par5). When the central bank wishes to tighten the money supply in the economy, it imposes some punitive rates on any bank wishing to obtain its funding. This discourages banks from accessing the funds hence reducing their ability to lend to their customers. This reduction in loanable funds constricts money supply. Interest rates rise as a result and inflation is also checked. When the central bank wants to loosen o expand money supply, it reduces the bank rate to levels which encourage commercial banks to access funds much easily. This boosts the ability of the banks to lend. At the same time, when the bank rate is low, the banks can lend out the funds got from central bank at much lower rates and still make some earnings. These two factors lead to enhanced lending by banks at low interest rates hence increasing money circulation in the economy. In addition to open market operations and the bank rates, central banks also use the reserve requirement rate to control money supply in the economy. Commercial banks are required by law to maintain a certain proportion of the funds as deposits with the central bank. These deposits are known as reserves and do not attract any interest. The rationale of holding these deposits is to mitigate the risk on behalf of depositors who deposit their money with the commercial banks but have no control of how the money is lent out and how secure their deposits are in the hands of banks willing to lend as much as possible to increase their interest rates. It is a very important indicator of the regulator’s (central bank) wishes in matters relating to interest rates. As a tool to for monetary policy, the reserve requirement rate can be increased or decreased by the central bank. When the reserve requirement rate is increased, the commercial banks have to divert more funds to the central bank as opposed to borrowers. As a result, their ability to expand credit offering is highly restricted. This means fewer amounts of loanable funds. Decreased supply of loanable funds attracts higher interest rates through the usual laws of demand and supply. At the same time inflation is reduced. This tool is however less often used by central banks because unlike the OMO and bank rates which are used to influence variables in the short term, this tool has more drastic effects on money supply and effects are largely long-term. In many cases, the tools are applied each at a time but for purposes of better understanding, an all inclusive expansionary monetary policy would constitute; the buying of government securities by the central bank; a reduction in the bank rate and; a reduction in the reserve requirement rate. The reverse would be true for a contractionary monetary policy; government securities would be sold to the commercial banks; the bank rate would be increased and the reserve requirement would be heightened. Of great importance is the link between the monetary aspect of the economy and the real economy. This link is established through the interest rates. Interest rates affect the investment levels in the economy which have a direct impact on the growth of the productive capacity of the economy and hence the growth levels of important variables such as output and employment rates. Therefore, the central bank seeks to use this link to influence economic growth in the economy. This process of employ the bank rate, retention rate and reserve rate is called money creation. One coefficient combining all these rates is called “the money multiplier” and it measures the extent to which the money creation process is able to grow money supply. The coefficient is the multiple by which the supply of money is greater than the actual existing monetary base. As a result, the implementation of the monetary policy has to be inconsideration of the money multiplier (Money multiplier, 2010, par3-7). In combating the irregularities in the economic growth rate, both monetary and fiscal policies are applied in tandem so as to realize the targeted goals. Depending on the economic environment in question, it may be necessary to apply say an expansionary fiscal policy and a contractionary monetary policy to take care of important issues such as inflation.
QUANTITATIVE EASING (QE) Definition As alluded to earlier, Quantitative easing is an extreme form of monetary policy which seeks to increase liquidity in the market even when the interest rates have already been reduced to almost zero and other expansionary monetary tools applied to the fullest. It is an unconventional monetary policy. Quantitative implies that a known amount of money is to be created through the QE process. Easing gives an indication that the policy is an attempt to ease the monetary limitations facing financial institutions like banks. The process is also at times referred to as “printing money” however, in reality; it amounts to shifting of money from financial instruments to the financial institutions. It starts with the central bank lowering the interest rate to as low as 0.5% or even 0%. This leaves no more room for application of expansionary monetary policy. The bank is then left with no choice but to create money out of nowhere, usually by just expanding the balance sheet and monetary base. The central bank then uses this money to buy government bonds from financial institutions (Dizikes, 2010, par1-6).
Overview
As has been mentioned earlier, QE is applied mainly in the developed world with minimal interest rates. The concept is largely new but gaining popularity in modern day management of monetary policy. Due to the abundance of credit coupled with political pressure at play in democracies, interest rates have been maintained at very low levels and justified by the need to increase access to funding hence increased productivity which leads to lower unemployment rates. Low unemployment rate is an important ingredient for social stability. Consequently, when such economies are hit by some economic shocks requiring the application of expansionary monetary policies, the flexibility required to effectively apply the policy is highly limited. Sometimes the central bank is sometimes left with a chance to reduce the interest rates by as low as 0.5%. In many cases, this is not adequate to trigger adequate increases in money supply required to trigger a correction of the economic shock being faced by the economy. Economists argue that QE works in two main ways. The first is the direct effect described above. It entails a direct surge in the bank’s accounts which avails more funds for lending. The second way is through using the cost of finance. After expanding its monetary base, the central bank is in a position to buy an incredible amount of bonds hence reducing the availability in the market. This then creates additional demands for new bonds and interest rates being low, the borrowing process for firms is made much easier. This then increases economic activity in the economy. Since it is clear that the short term interest rates are at the lowest points possible, it becomes important to project further and address the long-term rates of interest. QE addresses such problems. QE is currently in operations in several countries including the US.
Risks
QE has attracted a huge debate in recent years. Economists are sharply divided on the feasibility of applying QE as well as its ability to lift the economy from recession. Some only associate the concept to the olden day’s practice of simply printing more currency with the aim of expanding money supply but resulting in less significant impact on the real economy. Several risks are associated with the concept of QE as applied to date. The most obvious risk associated with QE is devaluation of currency. Economic principles dictate that any time an extra dollar is introduced in the economy, and then the value of the existing dollar is decreased. This is in line with the normal laws of demand and supply. This being the case then, action by government to pump huge sums of money into the economy through banking institutions which engage the money multiplier is bound to result in massive devaluation of local currency against foreign currencies. While this may be good news to exporters, it can very well spell doom for the currency’s value in international trade. Today, it is estimated that due to the application of QE by the US, the value of the dollar could decline by about 20%. Such sentiments have made countries such as China question the feasibility of using the US dollar as the world’s major currency. The second but equally important risk associated with QE is inflation. Economists argue that QE has the potential to trigger high inflation, even hyper inflation especially if improperly applied. This is likely to happen if the central bank employed QE and created too much money. High inflation can be catastrophic for a population already struggling with lowered incomes caused by an economic phenomenon such as a recession. This implies that application of this policy has to be done in a very controlled and monitored environment in order to spot any signs of excessive money creation. In addition, if the QE was to trigger some form of hyper inflation, it would be difficult to stop it. This is because many times, inflation is driven by perceptions which may remain unchanged when there is proof that QE could be a trigger. The effects of such scale of inflation would be disastrous to the economy. Remember, inflation is some form of hidden tax especially on people’s savings. This is because, overtime the value of money decreases marginally hence watering down the real values of savings including retirement benefits. When the recession starts from within the financial sector, it is difficult to trust the same industry with the recovery process. In the US, the recent economic recession started off within the financial sector which acted overzealously in extending credit hence pushing up housing prices unrealistically. Feeding the same financial institutions with the sums proposed under the QE policy so as to re-ignite credit uptake could lead to a similar case of over pricing in future. This means moving from one problem right to another one. As has been mentioned above, injecting more money in to the economy waters down the value of the currency. This according to economists could destabilize the entire globe’s financial system. Financial institutions start engaging in speculations hence increasing instability in the global systems. This could hurt many other countries in the process triggering diplomatic rows. In addition, QE has potential to introduce a currency war. This is because, the devaluation resulting would mean that local goods become cheaper in international markets while imports costly. The advantage here is for local manufacturers at the expense of foreigners. This could be viewed as a deliberate move causing other countries to start devaluing their currency as well hence the currency war as countries seek to expand exports. Too much devaluation would mean that the rest of the world’s central banks would not be willing to lend to a seemingly unstable economy. In the long-run this would mean that the options left for the country are few. Any need to borrow would be resisted by other central banks or if accepted, the interest rates would be much higher due to the higher perceived risks. According to analysts, the worst risk and which appears to manifest in the response to the financial crisis is a case where the banks even after having their loan issuance ability boosted, refuse to extend loans in tandem. Due to the high risk perception, they may deem it too risky to extend loans in an increasingly uncertain environment. The result of this is not only the failure of the economy to improve but also an elongated period of recovery. In general, the real risk of qualitative easing is not whether it works or not, rather the risk is seen in terms of the long-term risks it introduces and the fact that the length of time for which the policy holds determines the fatality of the risks involved.
Motivation of this research As mentioned above, the concept of QE has attracted much wider debate in recent times. This is because QE has largely been applied by different countries in dealing with the recent economic recession triggered by the financial crisis in the US. The US government has led the way in applying QE as a measure to get banks lending yet again. It passed a 900 billion dollar package to buy securities and even lend to some of the commercial banks in a bid to revive their activities. Even as the American economy recovers from the recession, questions are emerging on both the viability of the policy as well as its long-term effects on variables such as inflation and interest rates. It is therefore important that the concept is well understood, its history reviewed and its risks analyzed in order to either avert unnecessary fears or indeed reaffirm some notions already held by the public as concerns qualitative easing. This is the total motivation for this research paper.
Objectives of the research The most important areas of emphasis include defining QE and its closely related policies; establishing the environments requiring its application; assessing its successes and demerits as well as looking at the history of its application with special focus on Japan and the US. In doing these the paper seeks to establish: • The suitability of Quantitative Easing as a tool for managing money supply • The situations or environment requiring application of QE • Historical successes or failures of the policy with special focus on Japan and the US
Through this analysis, effectiveness of QE as implied by central banks in the recent actions is put to test. The effectiveness of the policy is of enormous interest for the entire world as it offers a great experiment of monetary policy in the face of low interest rate which is the case in most developed nations. The overall objective is to improve the understanding of quantitative easing as a concept and ensure that a larger pool of citizens especially investors understand the possible implications of the policy on the economy. The paper seeks to complete insufficient literature on QE.
Feasibility
This analysis demands substantial investments in terms of time as it is clear that the concept of Quantitative easing has not been widely acknowledged hence requiring more deeper investigations so as to unearth the reality. Again, the policy is currently in operation in the US hence the data available for the US is not complete. Completeness will be achieved years after the economy exits from the policy. More importantly, due to the fact that the concept is still considered new, much less scholarly article have been written to shed light on the academic base. As a result a significant part of the information available will be obtained from sources such as media commentaries and expert opinions on the subject. However, there is sufficient information on the definition as well as the risks associated to the policy. In addition to the expert articles, several interviews will be conducted among scholars who best understand economic policy in order to find out more on the largely unexplored topic. There are also constraints related to availability of time as the two months available to comprehensively explore the topic is not adequate. However, I plan to ensure that I secure interviews early enough in order to embark on the compilation process early enough.
History of Qualitative Easing QE is definitely not a new concept in the global economy. Almost over 200 years ago, the policy was applied in the UK in response to a banking crisis. However, by then it was not known as a QE but it worked in a much similar manner. The UK government responded to the financial crisis through by flooding the financial system with newly printed money. The “restriction period” around the year 1797 saw the first case of ‘printing money’. The British Prime Minister William Pitt ordered a quick response to the crisis facing the banking system after a raid by the French which was preceded by great demand for gold to funded the war and subsidize allies. The raid though unsuccessful gave the last blow to the system leading to unprecedented plummeting of banks and cities as well. The Bank of England had to print more notes based on the same amount of gold. Inflation shot up but later dipped to deflation however the disturbances were obvious. The panic of 1825 saw the second application of the concept. This year presented a typical bubble burst in the stock market. This was facilitated by a fraudster called Gregor Macgregor. He took advantage of the mess in the stock market and engaged in fraud which on exposure caused a run on the banks. Lord Liverpool requested that gold payments be suspended hence enabling him to give unofficial permit to the bank to print money and after the crisis was over; the economy reverted back to the gold standard. The third period of application was during the third world war. Governments expanded their monetary base in a bid to increase their ability to fund the war. In countries like the UK, inflation rates peaked at about 25% in the year 1917. However, the complete and eloquent rational to the policy was given by Irving Fischer, a renowned economist in the year 1933. According to Irving, the great depression was caused by “debt deflation” which led to a collapse in demand of assets. He argued that the best possible solution was through temporary expansion of the monetary base so as to engineer some inflation which would instill confidence among investors. This recommendation was endorsed by Milton Friedman. In his work named Monetary history of United States, he concurred that this was the only feasible solutions to forces of deflation in an economic environment already experiencing low interest rates. To date, Irving Fischer is still the most quoted economist by those advocating or implementing the QE policy such as the chairman of the US Federal Reserve and the governor of Bank of England. Throughout this time, the term used was ’printing money’. Dr Richard Werner from the University of Southampton in UK was the first economist to introduce the phrase Quantitative easing. He was in Tokyo. His intention was to introduce a different approach to monetary policy which did not rely on the interest rates linkage towards affecting the real economy. His suggestion was however inclined towards credit easing but the Bank chose to use the term to refer to an expansion of bank reserves.
Examples of Qualitative Easing
Japan
There are numerous examples of cases where QE has been applied. Two of these however stand out; this includes Japan and the US economies. In Japan, the year 2001 marked a paradigm shift in management of money supply. The Bank of Japan (BOJ) took the QE route towards the stimulation of an extremely sluggish economy. The BOJ increased the account balances owned by other banks as reserves to levels beyond the prescribed reserve levels (Oda, and Kazuo, 2005 par5). Bearing in mind the fact that reserve levels are important indicators to the ability of the bank to extend credit, the bank rate was also reduced to zero. Again, the BOJ gave assurances that the policy would be in place up to the time when the CPI would register a zero or a positive trend. This was important as the deflationary pressures were weighing down on investments. After a period of five years, the policy was stopped. A great deal of evidence has since surfaced concerning the success or failures of the policy in Japan (Baba, Motoharu, Yosuke, Kazuo and Hiroshi, 2005, p50). The effect of expanding current account balances is an important indicator of overall success. Initial efforts saw the current balance accounts rise from a trillion Japanese yen to 5 trillion. As a result call rates dropped from 0.15% to zero. In late dates, the current accounts were raised about 9 times. This enabled the balance to hit the upper limit targeted (Kobayashi, Mark and Nobuyoshi, 2006, p34). This was however achieved gradually through open market operations conducted monthly. The BOJ was very successful in keeping the monthly accounts within targets. The impact on Japanese bonds was noticeable. According to analysts, a 10 trillion yen rise in current account led to a reduction in the yield of Japanese bonds by between 17 and 19 basis points.
USA
Within the last three years, the US has faced the worst recession since the great depression. It all started with the burst of the housing bubble which saw the prices of overpriced houses plummet at an alarming rate. The prices had risen to unrealistic levels due to a largely unchecked credit market which ballooned demand to enormous heights. The crisis then spread to the rest of the financial sector before spreading to other sectors resulting in a global recession. According to the Federal Reserve chairman response to the crisis required a similar but adapted quantity easing policy. He stated that the QE would involve expanding the central bank’s balance sheet. However he was quick to state that the US response would be more comprehensive as it would focus on not only expanding the current account balances but also on the security markets as well as loans and their effect on businesses and households in terms of improving credit access. Despite the successes already being witnessed in terms of economic growth, the effectiveness of QE in the US is yet to be comprehensively determined. Indeed, the policy has attracted wide critics from analysts. Some argue that the policy has led to a deep devaluation of the dollar to the extent of upsetting the global economy and the repercussions may not favor the US. Others have observed that instead of lending locally, American banks are transferring the almost free huge amounts to other countries. Though the banks may benefit due to improved margins, effects on local industries and unemployment in the US are minimal. Comparison of USA and Japan There some striking similarities as well as differences between the US and Japanese application of the QE policy. Apart from the fact that the US policy was applied much recently, it is clear that the enormity of response by the two countries has a hug disparity. BOJ only grew its asset base by 75%. This is unlike the US Federal Reserve bank which grew its base by a staggering 140%. This is almost twice the percentage. This can be shown by the graphs below:-
Growth in current accounts in Japan
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Source: http://www.frbsf.org/publications/economics/letter/2006/el2006-28.html
Growth in current account balances in the US
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Source: http://www.frbsf.org/publications/economics/letter/2006/el2006-28.html
Again, the BOJ applied its policy when interest rates were as low as 0.1%, the Fed was already implementing the policy with interest rates as high as 2%. The accommodative bond market is also credited for the successful implementation of the policy. Analysts assert that the BOJ policy comes out more verifiable as opposed to the US policy. This is due to several reasons. First is the fact that the BOJ plan was clearly to be implemented until CPI rose to zero or above. The Fed has not communicated on the timing for the stoppage of the policy. The reason floated for this is the need for flexibility however the uncertainty elicited may counter the gains made especially in prices. The five year period had been determined by BOJ at the beginning (Okina, and Shigneori, 2004, p80). In addition, the exit strategies may differ raising fears of unforeseen circumstances. For Japan, the plan appeared to adopt a pattern of four years of easing and one year of tightening and analysts argue that this is one major factor which ensured stability in the economy even after exit. In America, talk is already gaining momentum on how best to exit the policy. This raises questions on whether the policy will indeed achieve much after being implemented for two years only.
Conclusion
Debate on the effectiveness of QE in managing economic crisis cannot be expected to end soon. Countries like the US are currently in the process of implementation. What is strikingly clear is the fact that QE presents higher risks as opposed to the conventional monetary policies. In addition, the success of the policy can only be evaluated on a case to case basis as the circumstances facing each economy at the time of implementing the policy are unique. All eyes are currently focused on the US economy. Despite the successes achieved so far, the long term implications could be serious. But if after exit the policy is viewed as a safer option given the former state of the US economy. However, the policy is an important addition to the mostly used policies and if used correctly has the potential to solve the worst of economic crisis. Even as the world waits for the US to portray the successes and failures, acceptance for the policy is still at a very low acceptance. Lots of analysis and understanding is required in order to successfully implement. The US model presents the most risky application hence the best benchmark to determine success.
Reference list
Akhtar, M. 1997. Understanding Open Market Operations. Public Information Department, Federal Reserve Bank. Available from, http://research.stlouisfed.org/aggreg/meeks.pdf
Auerbach,J., and Obstfeld, M. (2005). The Case for Open Market Purchases in a Liquidity Trap. American Economic Review 95(1) pp. 110-137.
Baba, N, Motoharu N, Yosuke S, Kazuo U, and Hiroshi U.( 2005). "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.
CliffsNotes.com. Fiscal Policy. 26 Nov 2010 .
Dizikes,P. (2010). Explained: Quantitative easing. MIT News Office. Available at,http://web.mit.edu/newsoffice/2010/explained-quantitative-easing.html
Galindev R. (2010) the Effect of Monetary Stabilization Policy on Long-run Growth. Available at, http://www.essex.ac.uk/economics/discussion-papers/papers-text/dp587.pdf
Kobayashi, T, Mark M. and Nobuyoshi Y. (2006). "Quantitative Easing and Japanese Bank Equity Values." Forthcoming, Journal of the Japanese and International Economies.
Monetary policy, 2010. Finpipe. Available at, http://www.finpipe.com/monpol.htm
Money multiplier, 2010. Money terms. Available at, http://moneyterms.co.uk/money-multiplier/
Oda, N, and Kazuo U. (2005). Bank of Japan Working Paper Series, No. 05-E-6. Available at, "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach."
Okina, K, and Shigneori S. (2004). "Policy Commitment and Expectation Formation: Japan's Experience Under Zero Interest Rates." North American Journal of Economics and Finance 15(1) pp. 75-100.
Stabilization Policy, 2010, Ingrimmayne. Available at, http://ingrimayne.com/econ/optional/MacroPolicy/Stabilization.html
Willem H. Buiter, (2010). Stabilization policy in New Zealand: Counting your blessings, one by one. Available at, http://www.nber.org/~wbuiter/nz.pdf
• Fiscal policy
• Open market operations
• Quantitative Easing
• Monetary policy
Quantitative Easing • Definition
• Overview
• Risks
• Motivation of this research ( why did you choice this topic)
• Objectives of the research
• Feasibility ( time and sources, any limitations)
History of Quantitative Easing Examples of the quantitative easing like (Japan and USA) Comparison of USA and Japan Conclusion References
Abstract
This paper discusses policy tools used by government in stabilizing the economic environment of a country. Apart from the common stabilization, monetary and fiscal monetary, the paper introduces the concept of quantitative easing which is gaining popularity in management of modern economies. It defines, gives an overview as well as a comprehensive explanation of the mechanics involved in implementing the policy. In addition, it gives insight on the historical perspective is highlighted with special reference to The Japanese and US cases. The paper ends with a summary conclusion tying all the concerns and expectations of the policy.
INTRODUCTION Economic development among societies is the single most important goal pursued by people across the world. Every individual, community, society and nation strives to achieve higher levels of development in order to avail higher and better living standards to the masses. The three most important parties in this development process are households, the firms and the government. Better economic performance is their common goal. Households strive to achieve better living standards; firms strive to achieve better profits while the government supports the achievement of these two goals. This is in a capitalist economy. In a bid to achieve these goals, the need to develop policies to harness the strengths of each of these economic units emerges. There are numerous policies targeting different aspects of the economy. In this paper, focus is on how governments apply policies in the management of the financial sector in order to achieve growth and development. The main policies of focus here include: the stabilization policy, fiscal policy, open market operations, quantitative easing and monetary policy. Special emphasis will be laid on quantitative easing where an in-depth analysis will be conducted on its effectiveness as well as its historical successes or failure in nations where it has been tried.
Stabilization Policy Before the 1930’s a majority of economists never thought that the government was in any position to offer viable solutions to problems facing the economy. Indeed they were very skeptical of any attempts by government or central banks to intervene as they believed that this would tamper with the self regulatory mechanisms in the market leading to irreparable instabilities. This long held view was upset by the great depression of the 1930’s. The sudden collapse of the US and consequently global economy showed signs indicating that the economy itself is inherently unstable. This inherent instability caused the collapse of the stock markets resulting in one of the most agonizing economic moments of history. Classical economists came to appreciate the cyclical nature of economic growth. Just like in many other aspects of life, the economy is characterized by periods of depressions and accelerated growth or a boom. Periods of depression are characterized by deflationary pressures; slowed productivity hence increased unemployment rates. This is definitely a concern for the authorities as it leads to diminished standard of living among the people threatening social stability (Willem, 2010, par4). In times of economic boom, the economy is characterized by high inflationary pressures, high productivity hence high employment rates. Despite the fact that these are desirable attributes, when they happen in extreme measures, the economy undergoes what economists call “overheating”. This has negative effects on the long term health of the economy (Stabilization Policy, 2010, par5). Consequently, economists agree that interventions by government are important in a bid to ensure a smoother trend of economic growth. Stabilization policy was accepted as it was clear that only the government had the ability to salvage the economy. Stabilization policy includes strategies put in place by government and the central financial institutions with the aim of keeping growth levels, prices and levels of unemployment in moderate levels to avoid the ills associated with both extremes i.e. the depression and the boom. Stabilization policies are aimed at reducing cases of erratic fluctuations in prices, output and unemployment. In addition to stabilizing, the policies are employed when economies are facing some specified shocks like the market crash and faults in sovereign debt. Under such circumstance, stabilization policies often come direct from the politic all class such as direct legislation and reforms in securities. It could also emanate from international players like the World Bank. Clearly, the aim is to apply all necessary measures to ensure that the economy adopts the smoothest trend possible. In most cases, the stabilization policy entails a combination of fiscal and monetary policies as well as additional policies which are specific to the problem. Applying stabilization policies has its advantages and disadvantages. In models of imperfect competition, economists argue that most stabilization policies introduce new rigidities in cases where the market is imperfect making the economy even less efficient. However in cases where the markets are operating in perfect competition, then the rigidities introduced by the attempts to respond to economic phenomena do not considerably affect the efficiency of the economy (Stabilization Policy, 2010, par6).
Fiscal Policy Fiscal policy is a tool used by governments in regulating the level of demand in the economy and hence regulates growth patterns. A recession presents a need for the government to explore ways of jumpstarting the economy. As mentioned above, a recession is characterized by low levels of production. A simple way of accelerating the production rate is through heightened demand. Bearing in mind the fact that the households are facing reduced incomes, the government has to come in and deploy money for various activities such as infrastructural development. This way, the government can accelerate growth rate or in the case of a boom, cut down the rate of growth. Consequently, fiscal policy basically entails expenditure by the government in goods and services but also the way in which the expenditure is financed. In reverse, fiscal policy can also be applied through reducing or increasing taxation or tax rates. This is because, the same way increased government spending seeks to raise the amount of money in the hands of the firms and consequently the households, a reduction in the tax rate enables firms and households to retain a bigger proportion of their incomes hence boost aggregate demand (CliffsNotes.com, par2). There are two main ways in which financing of government expenditure is done. First is using tax money raised from the general public. Secondly, the government may finance through borrowing. Ultimately, a rise or decline in level of government spending has direct impact on important economic variables such as aggregate demand mentioned above and equally important, resource allocation patterns as well as income distribution. In this case then the policy can be used to achieve socio-political goals in an economy (CliffsNotes.com, par5). The budget is the single most important vehicle with which fiscal policy is implemented. It basically stipulates both the sources of government funds as well as the way in which the funds are allocated to the different areas of priority to government. This being the case the two main ways in which the fiscal policy can be applied is through the expansion or contraction of government spending. Expansionary fiscal policy entails expanding government spending with the aim of lifting the economy from a sluggish growth rate. Contractionary policy is applied when the economy is experiencing a boom as a way of slowing it down. As concerns the funding mechanisms, the budget could be in three different stances. They include a budget deficit, a budget surplus and a balanced budget. A budget deficit stance means that the government spends more than it can raise through taxation hence requiring additional funds from borrowing. The most common borrowing instruments used by government include treasury bills and bonds which in most cases are called government papers. Borrowing locally or internationally has different repercussions for the economy. A balanced budget implies that the government spends as much as it is able to rise from taxation. This is a case of living within means. A budget surplus occurs when the government is raising more money through taxation than it is able to spend. The goal for most government is to achieve a balanced budget however in many cases the need to finance development projects pushes countries into perpetual budget deficits. Keynesian economists are strong proponents of the application of fiscal policies in reducing the cyclical nature of economic growth however classical economists express some reservation to this route. They express two main defects with the policy. First, when an expansionary fiscal policy is applied to boost aggregate demand but it turns out that the funds applied are raised through domestic borrowing, then there is a likelihood of “the crowding out effect”. This is a situation where the gains made through the expansionary policy are offset by the resultant high interest rates. High interest rates result when the government borrows money locally hence diverting funds which would have been borrowed by firms for investments. Reduction in the supply of loanable funds definitely leads to a rise in interest rates. High interest rates raises the cost of financing for investors hence less investors are willing and able to take up loans to scale up production activities. Consequently, the positive effects of expanding the government spending to boost aggregate demand is weighed down by the limitation in access to funding for the firms (CliffsNotes.com, par8). The second defect cited by classical economists is the fact expansionary fiscal policies decreases the net exports of a country which according to them is an important component of a country’s GDP. They argue that government borrowing increases interest rates in an economy hence attracting foreign investors who are in search of better returns. These foreign investors must first convert their funds from the foreign to local currency leading to a rise in demand for the country’s currency. An increase in demand for currency leads to a currency appreciation. The principles of international trade imply that an appreciation in local currency means that the cost of local goods in the foreign markets rises making them less affordable. The effect is a decrease in the level of exports. Again, the appreciation implies that foreign goods cost less in the domestic markets hence import levels rise. The overall effect then is a fall in the level of net exports for the country. In recent times, expansionary fiscal policies have been employed across the globe in the backdrop of one of the greatest recession in modern economies. The US leads with the injection of about 600 billion dollars in to the economy to jumpstart demand in different sectors of the economy. Other countries in Europe, Asia and Africa followed suite and about two years later, it appears that the global economy is coming out of the recession.
Open Market Operations (OMO) In an attempt to either control the liquidity levels in an economy as well as interest rates, central banks have a few options to consider. Top on those options is the open market operations. Open market operations basically involve the sale and purchase of government securities openly to interested investors. Government securities are issued in exchange of specific amounts of money and mature after a specified period when the money is refunded with some earnings. The two main government securities are treasury bills and treasury bonds (Akhtar, 1997, par5). When the liquidity levels in the economy is high, interest rates are low consequently firms are able to borrow more for production activities. However, if the economy is already experiencing high growth rates, the central bank may opt to ‘mop up’ excess liquidity from circulation hence increasing interest rates which in turn reduce the ability of investors to borrow and consequently, the growth rate is managed. ‘Mopping up’ in this case means selling government securities to investors and holding on to the money realized. On the other hand when the liquidity levels are low interest rates are likely to be high as demand for money is higher that supply. The central bank may opt to boost the economy through reduction in interest rates as a result of increased liquidity. This would entail buying back the government securities hence releasing money (Acerbic, and Obstfeld, 2005, p115). OMOs are highly effective in managing liquidity in the short run and medium term. Treasury bills last for periods as short as three weeks while bonds last much longer but usually do not exceed three years. In addition to managing interest rates, OMOs also help manage inflation as well as exchange rates. Inflation rates are high when liquidity is high as the ease with which money is available means that people may be willing to pay more for goods and services hence a rise in prices. When the excess liquidity is mopped up, there is less money available for spending hence limiting the ability of firms to hike prices. Effects on exchange rates occur due to the inflows and outflow of funds prompted by changes in interest rates as described earlier under fiscal policy. Notably, OMOs are part of monetary policy described below.
Quantitative Easing Quantitative easing is an extreme form of monetary policy. A shall be discussed under the sub topic ‘monetary policies’ below, central banks have great influence on interest rates in the economy and they often use this influence to regulate the growth rates. For example in times of low growth interest rates can be lowered to stimulate investments. Likewise, in times of extremely high growth, interest rates can be increased to slow down the ability of producers to scale-up their production. However, most developing countries are better placed to apply this tactic especially in periods of slowed growth because in these economies, interest rates are considerably high. In the developed world, the situation is different. Due to the high availability of capital, interest rates are at a very low level. Consequently, the flexibility is limited. Once the interest rate hits zero, it cannot be further reduced despite the fact that the economy may not yet be out of the recession. This problem has been addressed by developed countries like the US through the concept of quantitative easing. Quantitative easing is a rather unconventional tool whose popularity appears to be improving by the day. It is mainly seen as attempts by the federal or central bank to increase liquidity in the market but at the same time ensure that interest rates remain low in the long run. Usually, when central banks inject money into the economy, two variables are expected to change. First inflation rate is expected to increase and secondly, the interest rates fall in the short run. According to economists, when inflation rates are too high, the economy suffers and in many cases, the gains made by the prevalence of low interest rate in accelerating investments are lost. Consequently, as a reactive measure, the central bank has to act in order to tame inflationary pressures. However, any attempts to tame the inflation level cause interest rates to rise. Therefore, the final result in the long-run is that interest rates will have to raise yet again hence lowered investment. This then makes this kind of policy approach unsustainable and irregular. Quantitative easing comes in to introduce some level of consistency and macroeconomic stability required to give investors some confidence on the long term viability of investing in the economy.
Monetary Policy Just like fiscal policy, monetary policies are used by governments to regulate economic growth as well as achieve macro-economic stability in the economy. However, unlike the fiscal policy which is largely influenced by the political agenda, implementation of monetary policy is largely controlled by central banks which have the capacity to safely apply it. Just like the word monetary suggests, the policy targets the monetary aspect of the economy. This is by controlling amounts of supply of money in the economy. The linkages between the monetary and the real economy give life to the effectiveness of the policy in influencing the real economy. The most important target variables for this policy are the interest rates, exchange rates and inflation. Just like the fiscal policy, there are expansionary and contractionary monetary policies. Expansionary monetary policies entail efforts put in increasing the supply of money in the economy while contractionary policies seek to reduce the supply of money in the economy. Reducing or increasing money supply in the economy works through the normal laws of demand and supply to vary the level of interest rate, which at this moment cost of accessing money. Increased supply implies reduced interest rates while reduced supply results in increased interest rates. For inflation, higher supply implies higher inflation while tightened supply cubs inflation (Galindev, 2010, par3). There are three critical tools applied by central banks in implementation of monetary policy. They include Open Market Operations (OMO); discount window operations and Reserve requirements. OMO as described above involves the buying or selling of securities in the market and mainly to commercial financial institutions. The aim is to control the reserves held by commercial banks and hence determine their ability to issues loans to firms. When the central bank sells securities to the financial institutions, it drives down their reserves upon which they base their ability to issue loans. When the commercial bank’s ability to issue loans is curtailed, the money stock in the economy adjusts downwards to the levels desired. When the central bank buys back securities from these commercial institutions, it releases money and drives up the ability their ability to lend. This builds on the money stock in the economy. The second tool used by central banks is the Discount Window Operations. One of the most important roles of the central bank is “the lender of last resort’. Commercial banks borrow money among themselves to alter their lending capacities at different time periods. They charge each other some interest rate lower than the market rates. On the same breadth, the central bank which is endowed with significantly high state resources has an obligation to lend to commercial banks. Just then same way banks charge each other some interest rate, central banks charge commercial banks at a rate referred to as the ‘Bank rate”. This bank rate is an important tool for controlling the ability of banks to borrow from the central bank (Monetary policy, 2010, par5). When the central bank wishes to tighten the money supply in the economy, it imposes some punitive rates on any bank wishing to obtain its funding. This discourages banks from accessing the funds hence reducing their ability to lend to their customers. This reduction in loanable funds constricts money supply. Interest rates rise as a result and inflation is also checked. When the central bank wants to loosen o expand money supply, it reduces the bank rate to levels which encourage commercial banks to access funds much easily. This boosts the ability of the banks to lend. At the same time, when the bank rate is low, the banks can lend out the funds got from central bank at much lower rates and still make some earnings. These two factors lead to enhanced lending by banks at low interest rates hence increasing money circulation in the economy. In addition to open market operations and the bank rates, central banks also use the reserve requirement rate to control money supply in the economy. Commercial banks are required by law to maintain a certain proportion of the funds as deposits with the central bank. These deposits are known as reserves and do not attract any interest. The rationale of holding these deposits is to mitigate the risk on behalf of depositors who deposit their money with the commercial banks but have no control of how the money is lent out and how secure their deposits are in the hands of banks willing to lend as much as possible to increase their interest rates. It is a very important indicator of the regulator’s (central bank) wishes in matters relating to interest rates. As a tool to for monetary policy, the reserve requirement rate can be increased or decreased by the central bank. When the reserve requirement rate is increased, the commercial banks have to divert more funds to the central bank as opposed to borrowers. As a result, their ability to expand credit offering is highly restricted. This means fewer amounts of loanable funds. Decreased supply of loanable funds attracts higher interest rates through the usual laws of demand and supply. At the same time inflation is reduced. This tool is however less often used by central banks because unlike the OMO and bank rates which are used to influence variables in the short term, this tool has more drastic effects on money supply and effects are largely long-term. In many cases, the tools are applied each at a time but for purposes of better understanding, an all inclusive expansionary monetary policy would constitute; the buying of government securities by the central bank; a reduction in the bank rate and; a reduction in the reserve requirement rate. The reverse would be true for a contractionary monetary policy; government securities would be sold to the commercial banks; the bank rate would be increased and the reserve requirement would be heightened. Of great importance is the link between the monetary aspect of the economy and the real economy. This link is established through the interest rates. Interest rates affect the investment levels in the economy which have a direct impact on the growth of the productive capacity of the economy and hence the growth levels of important variables such as output and employment rates. Therefore, the central bank seeks to use this link to influence economic growth in the economy. This process of employ the bank rate, retention rate and reserve rate is called money creation. One coefficient combining all these rates is called “the money multiplier” and it measures the extent to which the money creation process is able to grow money supply. The coefficient is the multiple by which the supply of money is greater than the actual existing monetary base. As a result, the implementation of the monetary policy has to be inconsideration of the money multiplier (Money multiplier, 2010, par3-7). In combating the irregularities in the economic growth rate, both monetary and fiscal policies are applied in tandem so as to realize the targeted goals. Depending on the economic environment in question, it may be necessary to apply say an expansionary fiscal policy and a contractionary monetary policy to take care of important issues such as inflation.
QUANTITATIVE EASING (QE) Definition As alluded to earlier, Quantitative easing is an extreme form of monetary policy which seeks to increase liquidity in the market even when the interest rates have already been reduced to almost zero and other expansionary monetary tools applied to the fullest. It is an unconventional monetary policy. Quantitative implies that a known amount of money is to be created through the QE process. Easing gives an indication that the policy is an attempt to ease the monetary limitations facing financial institutions like banks. The process is also at times referred to as “printing money” however, in reality; it amounts to shifting of money from financial instruments to the financial institutions. It starts with the central bank lowering the interest rate to as low as 0.5% or even 0%. This leaves no more room for application of expansionary monetary policy. The bank is then left with no choice but to create money out of nowhere, usually by just expanding the balance sheet and monetary base. The central bank then uses this money to buy government bonds from financial institutions (Dizikes, 2010, par1-6).
Overview
As has been mentioned earlier, QE is applied mainly in the developed world with minimal interest rates. The concept is largely new but gaining popularity in modern day management of monetary policy. Due to the abundance of credit coupled with political pressure at play in democracies, interest rates have been maintained at very low levels and justified by the need to increase access to funding hence increased productivity which leads to lower unemployment rates. Low unemployment rate is an important ingredient for social stability. Consequently, when such economies are hit by some economic shocks requiring the application of expansionary monetary policies, the flexibility required to effectively apply the policy is highly limited. Sometimes the central bank is sometimes left with a chance to reduce the interest rates by as low as 0.5%. In many cases, this is not adequate to trigger adequate increases in money supply required to trigger a correction of the economic shock being faced by the economy. Economists argue that QE works in two main ways. The first is the direct effect described above. It entails a direct surge in the bank’s accounts which avails more funds for lending. The second way is through using the cost of finance. After expanding its monetary base, the central bank is in a position to buy an incredible amount of bonds hence reducing the availability in the market. This then creates additional demands for new bonds and interest rates being low, the borrowing process for firms is made much easier. This then increases economic activity in the economy. Since it is clear that the short term interest rates are at the lowest points possible, it becomes important to project further and address the long-term rates of interest. QE addresses such problems. QE is currently in operations in several countries including the US.
Risks
QE has attracted a huge debate in recent years. Economists are sharply divided on the feasibility of applying QE as well as its ability to lift the economy from recession. Some only associate the concept to the olden day’s practice of simply printing more currency with the aim of expanding money supply but resulting in less significant impact on the real economy. Several risks are associated with the concept of QE as applied to date. The most obvious risk associated with QE is devaluation of currency. Economic principles dictate that any time an extra dollar is introduced in the economy, and then the value of the existing dollar is decreased. This is in line with the normal laws of demand and supply. This being the case then, action by government to pump huge sums of money into the economy through banking institutions which engage the money multiplier is bound to result in massive devaluation of local currency against foreign currencies. While this may be good news to exporters, it can very well spell doom for the currency’s value in international trade. Today, it is estimated that due to the application of QE by the US, the value of the dollar could decline by about 20%. Such sentiments have made countries such as China question the feasibility of using the US dollar as the world’s major currency. The second but equally important risk associated with QE is inflation. Economists argue that QE has the potential to trigger high inflation, even hyper inflation especially if improperly applied. This is likely to happen if the central bank employed QE and created too much money. High inflation can be catastrophic for a population already struggling with lowered incomes caused by an economic phenomenon such as a recession. This implies that application of this policy has to be done in a very controlled and monitored environment in order to spot any signs of excessive money creation. In addition, if the QE was to trigger some form of hyper inflation, it would be difficult to stop it. This is because many times, inflation is driven by perceptions which may remain unchanged when there is proof that QE could be a trigger. The effects of such scale of inflation would be disastrous to the economy. Remember, inflation is some form of hidden tax especially on people’s savings. This is because, overtime the value of money decreases marginally hence watering down the real values of savings including retirement benefits. When the recession starts from within the financial sector, it is difficult to trust the same industry with the recovery process. In the US, the recent economic recession started off within the financial sector which acted overzealously in extending credit hence pushing up housing prices unrealistically. Feeding the same financial institutions with the sums proposed under the QE policy so as to re-ignite credit uptake could lead to a similar case of over pricing in future. This means moving from one problem right to another one. As has been mentioned above, injecting more money in to the economy waters down the value of the currency. This according to economists could destabilize the entire globe’s financial system. Financial institutions start engaging in speculations hence increasing instability in the global systems. This could hurt many other countries in the process triggering diplomatic rows. In addition, QE has potential to introduce a currency war. This is because, the devaluation resulting would mean that local goods become cheaper in international markets while imports costly. The advantage here is for local manufacturers at the expense of foreigners. This could be viewed as a deliberate move causing other countries to start devaluing their currency as well hence the currency war as countries seek to expand exports. Too much devaluation would mean that the rest of the world’s central banks would not be willing to lend to a seemingly unstable economy. In the long-run this would mean that the options left for the country are few. Any need to borrow would be resisted by other central banks or if accepted, the interest rates would be much higher due to the higher perceived risks. According to analysts, the worst risk and which appears to manifest in the response to the financial crisis is a case where the banks even after having their loan issuance ability boosted, refuse to extend loans in tandem. Due to the high risk perception, they may deem it too risky to extend loans in an increasingly uncertain environment. The result of this is not only the failure of the economy to improve but also an elongated period of recovery. In general, the real risk of qualitative easing is not whether it works or not, rather the risk is seen in terms of the long-term risks it introduces and the fact that the length of time for which the policy holds determines the fatality of the risks involved.
Motivation of this research As mentioned above, the concept of QE has attracted much wider debate in recent times. This is because QE has largely been applied by different countries in dealing with the recent economic recession triggered by the financial crisis in the US. The US government has led the way in applying QE as a measure to get banks lending yet again. It passed a 900 billion dollar package to buy securities and even lend to some of the commercial banks in a bid to revive their activities. Even as the American economy recovers from the recession, questions are emerging on both the viability of the policy as well as its long-term effects on variables such as inflation and interest rates. It is therefore important that the concept is well understood, its history reviewed and its risks analyzed in order to either avert unnecessary fears or indeed reaffirm some notions already held by the public as concerns qualitative easing. This is the total motivation for this research paper.
Objectives of the research The most important areas of emphasis include defining QE and its closely related policies; establishing the environments requiring its application; assessing its successes and demerits as well as looking at the history of its application with special focus on Japan and the US. In doing these the paper seeks to establish: • The suitability of Quantitative Easing as a tool for managing money supply • The situations or environment requiring application of QE • Historical successes or failures of the policy with special focus on Japan and the US
Through this analysis, effectiveness of QE as implied by central banks in the recent actions is put to test. The effectiveness of the policy is of enormous interest for the entire world as it offers a great experiment of monetary policy in the face of low interest rate which is the case in most developed nations. The overall objective is to improve the understanding of quantitative easing as a concept and ensure that a larger pool of citizens especially investors understand the possible implications of the policy on the economy. The paper seeks to complete insufficient literature on QE.
Feasibility
This analysis demands substantial investments in terms of time as it is clear that the concept of Quantitative easing has not been widely acknowledged hence requiring more deeper investigations so as to unearth the reality. Again, the policy is currently in operation in the US hence the data available for the US is not complete. Completeness will be achieved years after the economy exits from the policy. More importantly, due to the fact that the concept is still considered new, much less scholarly article have been written to shed light on the academic base. As a result a significant part of the information available will be obtained from sources such as media commentaries and expert opinions on the subject. However, there is sufficient information on the definition as well as the risks associated to the policy. In addition to the expert articles, several interviews will be conducted among scholars who best understand economic policy in order to find out more on the largely unexplored topic. There are also constraints related to availability of time as the two months available to comprehensively explore the topic is not adequate. However, I plan to ensure that I secure interviews early enough in order to embark on the compilation process early enough.
History of Qualitative Easing QE is definitely not a new concept in the global economy. Almost over 200 years ago, the policy was applied in the UK in response to a banking crisis. However, by then it was not known as a QE but it worked in a much similar manner. The UK government responded to the financial crisis through by flooding the financial system with newly printed money. The “restriction period” around the year 1797 saw the first case of ‘printing money’. The British Prime Minister William Pitt ordered a quick response to the crisis facing the banking system after a raid by the French which was preceded by great demand for gold to funded the war and subsidize allies. The raid though unsuccessful gave the last blow to the system leading to unprecedented plummeting of banks and cities as well. The Bank of England had to print more notes based on the same amount of gold. Inflation shot up but later dipped to deflation however the disturbances were obvious. The panic of 1825 saw the second application of the concept. This year presented a typical bubble burst in the stock market. This was facilitated by a fraudster called Gregor Macgregor. He took advantage of the mess in the stock market and engaged in fraud which on exposure caused a run on the banks. Lord Liverpool requested that gold payments be suspended hence enabling him to give unofficial permit to the bank to print money and after the crisis was over; the economy reverted back to the gold standard. The third period of application was during the third world war. Governments expanded their monetary base in a bid to increase their ability to fund the war. In countries like the UK, inflation rates peaked at about 25% in the year 1917. However, the complete and eloquent rational to the policy was given by Irving Fischer, a renowned economist in the year 1933. According to Irving, the great depression was caused by “debt deflation” which led to a collapse in demand of assets. He argued that the best possible solution was through temporary expansion of the monetary base so as to engineer some inflation which would instill confidence among investors. This recommendation was endorsed by Milton Friedman. In his work named Monetary history of United States, he concurred that this was the only feasible solutions to forces of deflation in an economic environment already experiencing low interest rates. To date, Irving Fischer is still the most quoted economist by those advocating or implementing the QE policy such as the chairman of the US Federal Reserve and the governor of Bank of England. Throughout this time, the term used was ’printing money’. Dr Richard Werner from the University of Southampton in UK was the first economist to introduce the phrase Quantitative easing. He was in Tokyo. His intention was to introduce a different approach to monetary policy which did not rely on the interest rates linkage towards affecting the real economy. His suggestion was however inclined towards credit easing but the Bank chose to use the term to refer to an expansion of bank reserves.
Examples of Qualitative Easing
Japan
There are numerous examples of cases where QE has been applied. Two of these however stand out; this includes Japan and the US economies. In Japan, the year 2001 marked a paradigm shift in management of money supply. The Bank of Japan (BOJ) took the QE route towards the stimulation of an extremely sluggish economy. The BOJ increased the account balances owned by other banks as reserves to levels beyond the prescribed reserve levels (Oda, and Kazuo, 2005 par5). Bearing in mind the fact that reserve levels are important indicators to the ability of the bank to extend credit, the bank rate was also reduced to zero. Again, the BOJ gave assurances that the policy would be in place up to the time when the CPI would register a zero or a positive trend. This was important as the deflationary pressures were weighing down on investments. After a period of five years, the policy was stopped. A great deal of evidence has since surfaced concerning the success or failures of the policy in Japan (Baba, Motoharu, Yosuke, Kazuo and Hiroshi, 2005, p50). The effect of expanding current account balances is an important indicator of overall success. Initial efforts saw the current balance accounts rise from a trillion Japanese yen to 5 trillion. As a result call rates dropped from 0.15% to zero. In late dates, the current accounts were raised about 9 times. This enabled the balance to hit the upper limit targeted (Kobayashi, Mark and Nobuyoshi, 2006, p34). This was however achieved gradually through open market operations conducted monthly. The BOJ was very successful in keeping the monthly accounts within targets. The impact on Japanese bonds was noticeable. According to analysts, a 10 trillion yen rise in current account led to a reduction in the yield of Japanese bonds by between 17 and 19 basis points.
USA
Within the last three years, the US has faced the worst recession since the great depression. It all started with the burst of the housing bubble which saw the prices of overpriced houses plummet at an alarming rate. The prices had risen to unrealistic levels due to a largely unchecked credit market which ballooned demand to enormous heights. The crisis then spread to the rest of the financial sector before spreading to other sectors resulting in a global recession. According to the Federal Reserve chairman response to the crisis required a similar but adapted quantity easing policy. He stated that the QE would involve expanding the central bank’s balance sheet. However he was quick to state that the US response would be more comprehensive as it would focus on not only expanding the current account balances but also on the security markets as well as loans and their effect on businesses and households in terms of improving credit access. Despite the successes already being witnessed in terms of economic growth, the effectiveness of QE in the US is yet to be comprehensively determined. Indeed, the policy has attracted wide critics from analysts. Some argue that the policy has led to a deep devaluation of the dollar to the extent of upsetting the global economy and the repercussions may not favor the US. Others have observed that instead of lending locally, American banks are transferring the almost free huge amounts to other countries. Though the banks may benefit due to improved margins, effects on local industries and unemployment in the US are minimal. Comparison of USA and Japan There some striking similarities as well as differences between the US and Japanese application of the QE policy. Apart from the fact that the US policy was applied much recently, it is clear that the enormity of response by the two countries has a hug disparity. BOJ only grew its asset base by 75%. This is unlike the US Federal Reserve bank which grew its base by a staggering 140%. This is almost twice the percentage. This can be shown by the graphs below:-
Growth in current accounts in Japan
[pic]
Source: http://www.frbsf.org/publications/economics/letter/2006/el2006-28.html
Growth in current account balances in the US
[pic]
Source: http://www.frbsf.org/publications/economics/letter/2006/el2006-28.html
Again, the BOJ applied its policy when interest rates were as low as 0.1%, the Fed was already implementing the policy with interest rates as high as 2%. The accommodative bond market is also credited for the successful implementation of the policy. Analysts assert that the BOJ policy comes out more verifiable as opposed to the US policy. This is due to several reasons. First is the fact that the BOJ plan was clearly to be implemented until CPI rose to zero or above. The Fed has not communicated on the timing for the stoppage of the policy. The reason floated for this is the need for flexibility however the uncertainty elicited may counter the gains made especially in prices. The five year period had been determined by BOJ at the beginning (Okina, and Shigneori, 2004, p80). In addition, the exit strategies may differ raising fears of unforeseen circumstances. For Japan, the plan appeared to adopt a pattern of four years of easing and one year of tightening and analysts argue that this is one major factor which ensured stability in the economy even after exit. In America, talk is already gaining momentum on how best to exit the policy. This raises questions on whether the policy will indeed achieve much after being implemented for two years only.
Conclusion
Debate on the effectiveness of QE in managing economic crisis cannot be expected to end soon. Countries like the US are currently in the process of implementation. What is strikingly clear is the fact that QE presents higher risks as opposed to the conventional monetary policies. In addition, the success of the policy can only be evaluated on a case to case basis as the circumstances facing each economy at the time of implementing the policy are unique. All eyes are currently focused on the US economy. Despite the successes achieved so far, the long term implications could be serious. But if after exit the policy is viewed as a safer option given the former state of the US economy. However, the policy is an important addition to the mostly used policies and if used correctly has the potential to solve the worst of economic crisis. Even as the world waits for the US to portray the successes and failures, acceptance for the policy is still at a very low acceptance. Lots of analysis and understanding is required in order to successfully implement. The US model presents the most risky application hence the best benchmark to determine success.
Reference list
Akhtar, M. 1997. Understanding Open Market Operations. Public Information Department, Federal Reserve Bank. Available from, http://research.stlouisfed.org/aggreg/meeks.pdf
Auerbach,J., and Obstfeld, M. (2005). The Case for Open Market Purchases in a Liquidity Trap. American Economic Review 95(1) pp. 110-137.
Baba, N, Motoharu N, Yosuke S, Kazuo U, and Hiroshi U.( 2005). "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.
CliffsNotes.com. Fiscal Policy. 26 Nov 2010 .
Dizikes,P. (2010). Explained: Quantitative easing. MIT News Office. Available at,http://web.mit.edu/newsoffice/2010/explained-quantitative-easing.html
Galindev R. (2010) the Effect of Monetary Stabilization Policy on Long-run Growth. Available at, http://www.essex.ac.uk/economics/discussion-papers/papers-text/dp587.pdf
Kobayashi, T, Mark M. and Nobuyoshi Y. (2006). "Quantitative Easing and Japanese Bank Equity Values." Forthcoming, Journal of the Japanese and International Economies.
Monetary policy, 2010. Finpipe. Available at, http://www.finpipe.com/monpol.htm
Money multiplier, 2010. Money terms. Available at, http://moneyterms.co.uk/money-multiplier/
Oda, N, and Kazuo U. (2005). Bank of Japan Working Paper Series, No. 05-E-6. Available at, "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach."
Okina, K, and Shigneori S. (2004). "Policy Commitment and Expectation Formation: Japan's Experience Under Zero Interest Rates." North American Journal of Economics and Finance 15(1) pp. 75-100.
Stabilization Policy, 2010, Ingrimmayne. Available at, http://ingrimayne.com/econ/optional/MacroPolicy/Stabilization.html
Willem H. Buiter, (2010). Stabilization policy in New Zealand: Counting your blessings, one by one. Available at, http://www.nber.org/~wbuiter/nz.pdf
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