Through Quantitative Easing Central Banks Buy Long-Term Government Bonds with Newly Printed Money - Research Paper Example

Debate on quantitative easing and its effect in the economy Lecturer Due Introduction Central banks purchase government treasury bonds through an unconventional policy in order to lower interest on short term loans. Quantitative Easing (QE) is a monetary policy the central bank implements to reduce the interest rate on short term loans (Buckley, 2009). The Central Bank’s aim is to flood financial institutions such as banks with money to promote liquidity and lending. When the Central Bank’s aims at boosting economic growth rate, it buys government bonds, which decreases interest rates on short term loans (Buckley, 2009). However, QE loses its effectiveness when the interest rates drops to almost zero. Inflation occurs as a result of a lot of money in circulation; QE may lead to inflation since it increases money supply to the public. Therefore, QE can lead to slow economic growth rate eventually due to cases of inflation. Several economists have raised their concern about the efficacy of QE to economic growth. Despite its short term solution to economic growth rate, QE is not an ultimate solution for nations in terms of economic growth rate. It bears both several advantages and disadvantages. Therefore, it is significant to study the advantages of QE and its disadvantages to the economy. By creating awareness on the pros and cons of QE, economies can implement QE, but at the same time control it to prevent jeopardizing the economy. The Federal Reserve, ECB, BOJ, and BOE implemented QE. Purpose for the project Economists in several countries believe that Quantitative Easing is not a reliable answer when it refers to boosting economic growth. There is a dispute over whether Quantitative Easing works. They believe that it only assists the economy for a short time and leads to cases of inflation. This term paper aims at providing information about the pros and cons of Quantitative Easing. The project’s main aim is to make people understand that QE fuels economic growth rate through maintaining price levels and containing inflation. However, this solution may damage the economy if banks do not set limits on what amount they lend to investors. A research will be conducted during the project to find out how QE works out for different economies. It also aims at finding out what suggestions are there on how to use QE. The Federal Bank, Bank of Japan, and European Central Bank implemented zero monetary policy to concur the economic crisis that had hit them. All economies aimed at containing inflation issues and reduce market distress. QE achieved some of the goals but concurrently failed at achieving other goals. It saved the Federal Reserve from bankruptcy and helped stabilize the economy. It did the same for the Japanese and European economies. However, the European Bank, Bank of Japan, and the Federal Reserve had to pursue less monetary policies such as QE due to fear of inflation which may lead to poor economic growth. Through this interpretation, the question on QE’s eligibility rises. Literature review Figure 1: Interest rate in % over the five years (Fawley, 2013) Figure 2: Rate of inflation for the four central banks (Fawley, 2013) Analysis of the Graphs An analysis of the graphical images above display how the interest rates lowered as a result of buying treasury bonds by all four central banks. For each country, such as Federal Reserve, the interest rate was at close to 6% in 2007. With the implementation of QE, it progressively decreased close to 0% by 2009. The same case applied to the Bank of England, ECB, and Bank of Japan. The economic recession rate in 2007 led to a state of deflation as shown in fig2, which affected America, Europe, U.K, and Japan. With the introduction of zero monetary policy, inflation rates rose indicating economic growth. However, in 2009 inflation rates declined to negative rates. This was as a result of financial institutions holding money to conquer the rising inflation rates. Between 2009 and 2010, QE was implemented hence, the rise in inflation rates again (Fawley, 2013). Real Life Examples The federal government requires a 10% reserve deposit by banks’ vaults in cash. When the Federal Reserve issues more credit to financial institutions, banks have more money to lend. Banks lower their interest rate allowing investors to borrow more money hence facilitating the development of projects. Through projects, employment, and self-production the economy of the nation is likely to grow since there is high GDP. In USA, through increased money supply, QE program lowered the value of the dollar hence increasing foreign investment through Stock sales. This made the country’s exports relatively cheaper. On November 2008, the Reserve announced a purchase of $800 billion in bank debt. However, it ended up purchasing more than it had declared. The Reserve’s purpose was to increase the central bank’s reserves hence it bought $ 175 million in Mortgage Backed Securities (MBS) that originated from Fannie Mae and Freddie Mac. They also purchased bonds worth $1.25 trillion MBS that Mortgage giants had pledged (Neville, 2013). The Federal Reserve ended up halting purchases by June 2010 since the economy had grown. The Reserve, however, had to halt the program since the economy started dwindling again. It bought $30 billion a month in the long term to keep lesser holdings. In case of QE2 in November 2010, the Fed increased quantitative easing with the aim of increasing inflation (Reith, 2011). When a country expects to suffer from inflation people tend to buy products now due to high pricing during inflation. Concurrently this boosts the economy. Despite some of its achievements, the program failed to achieve making more credit available. Inflation is another negative impact of Quantitative Easing that affected the United States. In the early 1990s, Japan’s economy suffered a lot of damage. Major financial institutions such as the Hokkaido Takushoku became bankrupt (Yutaka, 2011). The Bank of Japan (BOJ) implemented the use of QE which reduced inter-bank interest rates to almost zero percent. This was done in 1999 to 2000, where the BOJ provided funds to encourage the interest rate to lower. In 1999, the country declared its submission to the program until elimination of deflationary worries (Yutaka, 2011). The policy brought about anxiety in investors since they expected low future returns and increased pricing on products. When a country expects inflation in the future, consumers and producers tend to invest now hence increasing present economic growth. This was Japan’s major aim for implementing QE. The same concept can be viewed in fig. 2 where inflation rates rose as expected to approximately 2.3 Percent in 2009. Other including the United Kingdom and Europe have applied the Quantitative Easing technique to boost the growth of their economies. The Bank of England and European Central Bank pursued the technique to stimulate economic growth in their respective economies (Reith, 2011). Academic research conducted states that for some time the technique assisted in boosting the economy for both Europe and U.K. (Neville, 2013). However, as the interest rate lowered towards zero the economic growth rate shifted to the negative side due to inflation. Judging from the review done, the motion on whether Quantitative Easing works assists or destroys economies still remains unsettled. Economic analysts explain that success differs with the subject economy and management of the program by respective economies. All four major economies implemented the program in order to boost their economies. Quantitative Easing reduced financial market troubles, assisted in hitting inflation targets, stimulating growth of the economy, and containing the European debt crisis (Neville, 2013). All this was for a short period as QE could not perform when implemented on a long term basis. Discussion of the question Therefore, it is true to indeed say that there is a problem with QE which puts many economies in a dilemma. Independent reporters on the world economy and financial markets for CFOs, bankers, investors, and treasures came up with a table of the pros and cons of Quantitative Easing. Through the discussion provided, economies can understand the pros and cons of QE hence know how to apply it. The table provides a number of advantages and disadvantages which economies can use to determine whether QE works or not. It has the following advantages: Buying up large quantities of treasury bonds reduces long term interest rates. This is essential because long term interest rates are much more important in growth of the economy. The same also applies for short term interest rates. Forcing down interest rates gives investors an opportunity to venture into riskier opportunities since return is higher. It increases an investment in stocks both locally and internationally hence building the economy. Quantitative Easing reduces the value of the local currency which can be an advantage to a country’s economy. It attracts foreign investment into the country and eases foreign trade between countries. Through investment and trade economic growth yields positively. However, besides it boosting economies, it also has several disadvantages. It does not solve the entire economic problem; it only succeeds for a set period. Despite it being an advantage for investors to venture into riskier business opportunities, it could be a major drawback for the economy if they fail to achieve their goals. The temporary nature of QE is a disadvantage on its own. Through lending money to financial institutions, the rate of money circulation within the economy rises. This pilot to a high rate of inflation which is a major drawback to the economy. Method The research study carried out involves an observation of the economic trends in US, UK, European and Japanese economies after employing QE. Sources of data include internet, journals and newspapers. An interview with an economist working with the Federal government assists in understanding how QE can be used efficiently. Procedure An observation of the US Federal Reserve statistics, Bank of Japan records, European Central Bank, and Bank of England records in several journals was carried out. The observation includes studying when the country implemented Quantitative Easing. The second observation includes studying what effects QE had on the respective economy for a period of five years. Finally, observing whether the program succeeded or failed the respective economies. The interview with Federal Economist constituted the following questions: What is Quantitative Easing? What causes Economies to apply this program? What are the positive returns of Quantitative Easing to the economy? What are the negative of Quantitative Easing to the economy? How does QE affect the economy of a nation? Is it a suitable solution to boost economies? What is your personal opinion as an economist about QE? Does it work or not? How can it be coordinated to assist the economy? Results The Federal Reserve did buy bonds worth $175 million and $1.25 trillion after a declaration of $800 billion. The program bore positive results and improved the economy. However, the trend was unstable due to on and off successes (Hausken, 2013). The economy rose and fell occasionally even after four Quantitative Easing reviews. The Bank of Japan implemented QE after the economic crisis in 1990s. The aim of the Japanese government was to boost the economy by spurring inflation (Bowman, 2011). Through inflation, investors and consumers would invest now while anticipating harsh economic times. Just as the Federal Reserve, the economy rose and fell occasionally. However, to the Japanese economy it was more of a success than a failure. In December 2011 and February 2012, the ECB injected large amounts if reserves in European banks to reduce the debt crisis. ECB increased reserves at a rate of 1% for a three year term (Hausken, 2013). The central bank’s intention was to lower interest rates hence boosting the economic growth. However, the crisis is not yet over economists opposes the Quantitative Easing idea due to the fact that other economies have tried and failed. The interview results indicate that Quantitative Easing works but at the same time fails after some time. QE assists economies that require a quick way to boost the economy. On the other hand, economic growth starts to drop due to several factors brought about by inflation. If economies can find ways of coordinating supply of money to reserves and controlling the consequences, QE can boost economic growth before the nation decides to apply long term solutions. An economy should weigh the advantage of implementing the program and the disadvantage of doing the same. The need for fast economic growth propels nations to implement the technique. Quantitative Easing works but should not be used as a long term solution for economic growth. Conclusion Central banks responded to the economic crisis through implementing various monetary policies. Sluggish economy and decline in economic growth lead to troubled financial markets in the country. In response, the Bank of Japan, United Kingdom, United States, and Europe developed policies to boost and aid in fast economic growth. To allow quick response, Central Banks implemented Quantitative Analysis so as to lower short term interest rates. Through results gathered from the various economies proliferating, QE led to the achieving of premeditated goals. However, it is tricky to foretell on a larger scale the effects of the program towards the broader economy. Despite the amount of research done, there is not enough information and comparison of effects of QE in the four central banks. An economic analysis indicates consistency in sharp economic growth for all four central banks. Concurrently results show that the program was quite a failure when it came to the broader economy for all four economies. Recommendations Based on the high advantages Quantitative Easing has on short term results, economies should embrace it. When someone is in a dire condition, it is better to find the quickest way to recover or else die. For a nation suffering from fatal economic conditions such as low Gross Domestic Product, Quantitative Easing is appropriate for it supports quick economic recovery. Through lending money to banks, interest rate lowers on loans providing investors with funds to create businesses (Krishnamurthy, 2011). It is also appropriate when a country aims at improving the economy on a short scale. For example, if the government aims at boosting a certain section of the economy such as agriculture. Quantitative Easing is advisable with funds supporting farmers hence that section of the economy develops positively. However, in terms of large scale and long term economic operations Quantitative Easing is not advisable. With large sums of money in circulation, a country is likely to suffer from inflation (Krishnamurthy, 2011). Inflation leads to loss of currency value. As a result, foreign trade and local production lowers leading to a decline in the economy. There central banks should look for better long term policies such as offering subsidies to various sectors to boost production. Through subsidies, the government can control and coordinate the amount of money lent out. Quantitative Easing works for economies when applied on a short term basis. All four major economies implemented the program in order to boost their economies. Analysis indicates consistency in sharp economic growth for all four central banks. However, results show that the program was quite a failure when it came to the broader economy for all four economies. Quantitative Easing works but only works for short term courses not long term. References Buckley, P. J. (2009). Business history and international business. Business History, 51(3), 307-333. Bowman, D. (2011). Quantitative easing and bank lending evidence from Japan. Washington, D.C.: [Federal Reserve Board]. Fawley, B. .., & Neely, C. J. (2013). Four Stories of Quantitative Easing. Federal Reserve Bank of St. Louis Review, 95(1), 51-88. Hausken, K., & Ncube, M. (2013). Quantitative Easing and Its Impact in the US, Japan, the UK and Europe. New York, NY: Springer New York :. Krishnamurthy, A., & Jorgensen, A. (2011). The effects of quantitative easing on interest rates channels and implications for policy. Cambridge, Mass.: National Bureau of Economic Research. Neville, P. (2013). Historical dictionary of British foreign policy. Choice Reviews Online , 50(12), 50-6535-50-6535 Reith, M. (2011). Unconventional monetary policy in practice: a comparison of Quantitative Easing in Japan and the USA. International Journal of Monetary Economics and Finance, 4(2), 111. Yutaka, K. (2011). Recent Japanese Monetary Policy: An Evaluation of the Quantitative Easing. International Journal of Business , 11(1), 1. Read More