What Is Quantitative Easing - Essay Example

Assessment 2 a) What is QE (quantitative easing)?{5 marks} Quantitative easing is the creation of new money and increasing its amount supplied while at the same time sinking the pressures on the banks, which is normally because of liquidity shortage risks. Thus, the increased supply of money increases the liquidity and the reserves while at the same time stimulating the process of banks lending money to the public. The quantitative easing tools used by central banks embrace lending money to the banks, purchasing government debts and assets belonging to the bank (Yotov, 2013, p. 64). This is the opposite of the traditional operation of open market policy, whereby the federal government buys and sells securities to change money supply to keep federal fund rates at a specified target value (Carbaugh, 2013, p. 361). Historically, researchers perceived QE as being negative to the currency because increase in supply of money may lead to inflation thus devaluing state’s currency (Yotov, 2013). However, in recent years there have been arguments suggesting QE is not necessarily bad for the currency. These arguments imply that there are benefits to QE when its usage is for the creation of inflation to avoid deflationary periods in the economy. This leads to quick economic recovery after a prolonged recession (Yotov, 2013, p. 64). According to Carbaugh (2013, p. 361), QE is not an exact science and there exists a debate on its effectiveness or lack thereof. Nevertheless, QE is a last resort measure used to stimulate the economy. b) How has QE (quantitative easing) impacted the money market and interest rate in the US since 2008? Provide a detailed explanation and diagrams. {5 marks} The US Federal government has utilized quantitative easing several times. The first time was in 2008 that extended until March 2010. The original value was supposed to be $600 billion but in the end, the Fed had used $1.75 trillion (Costa, 2014). This Fed spread the amount on the mortgage-backed securities and the Treasury notes. The second quantitative easing included adding $600 billion in form of Treasury securities, which are long-term in nature (Costa, 2014). The Federal purchased the Treasury securities from November 2010 to 2011 June. The quantitative easing had several effects on the US interest rates and money market (Costa, 2014). The first effect of the QE was that it resulted to a surge of stock prices. When the Fed announced the first QE, money market experienced a big rally in the prices of stock. The S&P 500 gained by 36.4 percent when it elevated from 857.4 to 1,169.4 (Costa, 2014). The increase was from 25 November 2008 to 31 March 2010. The second QE fuelled the rally even more as the S&P 500 gained by 26 percent when it increased from 1,049 to 1,320 (Costa, 2014). The increase was from 31 August 2010 to 30 June 2010 (Costa, 2014). The second impact of the QE was unexpected. The QE affected bond yields, which are long term. The two major QE’s employed in the US ended up depressing yields temporarily. When the Fed begun the purchase of government securities, the prices actually fell, which made yields to rise. In turn, investors drove the new liquidity into even more risky assets and went further to sell their holdings stored in the Treasuries (Costa, 2014). The third impact of the QE was that it resulted to a depreciation of the US dollar and the surging of the gold prices (Costa, 2014). The purchase of large amounts of Treasuries flooded the US dollar circulating in the market. This made the demand for the US dollar to drop. Since people consider gold a hedging commodity, the prices of gold skyrocketed. This is because there was an expectation of inflation due to the QE’s (Costa, 2014). Money supply then augmented greatly after the first two QE’s. This was when Fed added money to the economy, through the purchase of government bonds, which resulted to an increase of its circulation. This in turn made the prices of commodities to increase especially those of oil and gold, hence leading to inflation. During the first QE, inflation dropped for a few months. The deflation was due to the outflow of capital as Fed had expanded the program for buying mortgages. Consequently, this prompted to significant rise of inflation after the completion o that period (Costa, 2014). c) Has quantitative easing in the US impacted the market for loanable funds in the US? Discuss any other relevant influences on the demand and supply in the market for loanable funds. {2 marks} In 2008 after the US fiscal plunged into recession, traditional monetary policy of reducing loans that are short-term by purchasing government securities (which are also short-term) could not work (Carbaugh, 2013). Therefore, Fed implemented quantitative easing that encompassed reduction of long-term interest rates, using QE to make mortgage loans more affordable. In turn, this was to stimulate the construction industry. However, there was a huge overhang for vacant houses not sold (Carbaugh, 2013). For the overhang to end, it will take a long time. Even though more money is floating around, the goods available for sale are fixed. This may lead to inflation. Moreover, by QE keeping the long-term interests low, the US government does not have to deal with large deficits in its budget (Carbaugh, 2013, p.361). d) What effect did quantitative easing have on the value of the American dollar?{2 marks} The quantitative easing made US dollar to depreciate due to the purchase of large amounts of Treasuries that flooded the US dollar circulating in the market. This made demand for the US dollar to drop. Moreover, the quantitative easing involved printing huge amounts of the dollar thus relying on foreign donors and the central banks to continue holding the dollar. The loose monetary policy lowered the price of the US dollar without changing its status (Gindin & Panitch, 2012, p.326) e) Use aggregate demand and supply to discuss the current state of the US economy and discuss the effects of quantitative easing on aggregate demand. {5 marks} Financial crisis that hit economy recently and ensuing recession put the economy’s productive capacity on a very low and shallow trajectory. The trajectory is lower than the one that was in place before 2007. The current GDP is approximately 7 percent below the level it was before 2007 (Reifschneider, 2013, p.2). The fallout from the GDP on the availability of credit, confidence and balance sheets continue to weigh on aggregate demand. This restrains housing market recovery pace, firms being willing to invest and hire and the expenditure by the government and other consumers. These effects in demand have diminished the economy’s productive capacity. Kiley, (2012) argues long-term interests brought about by quantitative easing influences aggregate demand way beyond effects expected with short-term interest rates. However, short-term interest rates that are expected exert large effects on aggregate demand, even more than that exerted by term premiums. This is consistent with the imperfect substitutability model of aggregate demand’s associated implications and financial instruments. No discussions about potential effects of the adaptation of quantitative easing on aggregate demand and long-term interests have brought out much difference between its impacts in the term premiums or rates short-term interest. Therefore, term premiums movement has very small effects on real activities than movements of short-term interests expected. This applies to the movements with equal sizes in the ling-term interests. f) Why are investors worried about the Federal Reserve tapering of quantitative easing?{2 marks} The QE increased the US capital outflow. When the global financial crisis was at peak, the US experienced the largest outflow of capital. This was from April – December of 2008. The capital inflows fuelled the capital market from the beginning of 2009. Even though the inflow of capital, especially direct investments, resumed in 2009, the overall investments in the US experienced outflows in the net capital. The effect made sense, as the US returns are extremely bad. Thus, it is very natural for investors invest elsewhere, especially in emerging countries (Desai, 2011). g) What effect did QE have on emerging economies? {4 marks} Quantitative easing is not appropriate for most emerging economies because financial stress have not been very severe and underlying inflation is higher. Therefore, only a few countries have had to move to a near zero policy. Moreover, the emerging economies are vulnerable to external shocks. This requires policy rates maintained at sufficient levels to compensate currency holders for the exchange rate risk. The quantitative easing brought about a capital outflow for all the economies that were externally vulnerable (Ishi, Stone & Yehoue, 2009, p. 16). Central banks in the emerging economies do not enjoy credibility that makes it possible to use highly discretional and less transparent unconventional measures. Therefore, these unconventional measures did not play as important a policy role in emerging economies as it did to the advanced ones. In addition, the use of unconventional measures by the emerging economies central banks raised difficult analytical issues with which researchers and the central bankers will be grappling with for many years to come (Ishi, Stone & Yehoue, 2009, p.16). PART 2 What kind of exchange rate system does China follow? How is the exchange rate system managed? What are the implications of the exchange rate on Chinese aggregate demand and inflation? Explain using diagrams. {5 marks} The Mainland China currently uses the renminbi exchange rate. China announced in 2005 its switch to the new exchange rate system. The exchange rate system is set with a reference to the other currencies’ basket, with the announcing of the numerical weights, allowing its movement of 2% either + or – in any given day. Even though the public policy circles accepted this step by china at face value, there is skepticism. Authorities in the Mainland have managed the renminbi exchange rate very well maintaining its stability against the dollar dating back to mid-2008 (Fan, 2010, p.1). Kroeber (2014) contends China manages its exchange rate system by making it more market determined and flexible. The authority’s intent is to switch to a monetary policy that targets mainly domestic interest rates from one that targets the exchange rates mainly. The renminbi policy change is part of an ambitious and broad strategy for financial reform, which reflects their agenda. The management involves improving the country’s macroeconomic objectives and does not have anything to do with boosting China’s exports. The most direct way in which the renminbi exchange rate can affect consumer inflation is through change in the prices of goods that are imported. Domestic factors play an important role in determination of inflation, even more than the external factors (Fan, 2010, p. 1). Chart 1 shows that in the last two decades, there was no association between consumer inflation and price inflation for the imports except in 2008 whereby the surge in global commodity price increased inflation. Chart 2 shows the close relationship between the consumer price inflation and the price of housing inflation from the 1990s. However, the graph has some lags. There is a possibility that a strong renminbi can have an impact on the aggregate demand. If this leads to a widening gap in the output, there would be an upward pressure, which would increase the country’s price level, and vice versa. Net effects of the renminbi appreciating on aggregate demand will most likely be negative (Fan, 2010). This is because there is an expectation of the wealth effects and the positive income being more than the negative impacts (Fan, 2010, p. 3). References Top of Form Top of Form Top of Form Top of Form Bottom of Form Bottom of Form Bottom of Form Top of Form Carbaugh, R. J. 2013. Contemporary economics: an applications approach. Cincinnati, South-Western College Pub. Costa, Polyana. 2014. Financial Crisis Timeline: Collapse and Bailout. [Online] Bankrate. Available at: http://www.bankrate.com/finance/federal-reserve/financial-crisis-timeline.aspx [Accessed 17Th September 2014] Desai, P. 2011. From financial crisis to global recovery. New York, Columbia University Press. Fan, Kelvin. 2010. Implications of a renminbi appreciation for inflation in Hong Kong. [pdf] Hong Kong Monetary Authority Quarterly Bulletin. Available at: http://www.hkma.gov.hk/media/eng/publication-and-research/quarterly-bulletin/qb201006/fa1.pdf [Accessed 17Th September 2014] Gindin, S., & Panitch, L. 2012. The making of global capitalism: the political economy of American empire. London, Verso. Ishi, K., Stone, M. R., & Yehoue, E. B. 2009. Unconventional Central Bank measures for emerging economies. [Online] International Monetary Fund. Available at: http://site.ebrary.com/id/10369368. [Accessed 17Th September 2014] Kiley, Michael T. 2012. The Aggregate Demand Effects of Short- and Long-Term Interest Rates. [Online] The Federal Reserve Board. Available at: http://www.federalreserve.gov/pubs/feds/2012/201254/ [Accessed 17Th September 2014] Kroeber, Arthur R. (2014). New Rules of the Game for China’s Renminbi. [Online] Brookings. Available at: http://www.brookings.edu/research/opinions/2014/05/14-new-rules-china-renminbi-kroeber [Accessed 17Th September 2014] Reifschneider, Dave. (2013). Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy. [pdf] 14th Jacques Polak Annual Research Conference November 7-8, 2013. Available at: https://www.imf.org/external/np/res/seminars/2013/arc/pdf/wilcox.pdf rereret Yotov, I. (2013). The quarters theory the revolutionary new foreign currencies trading method. Hoboken, N.J., Wiley. Read More