Optimal Monetary and Fiscal Policy in a Liquidity Trap - Assignment Example

Macro and Micro Economics Macro and Micro Economics Part a. Quantitative easing is an exceptional economic policy set by central banks to spur up the economy in the event typical fiscal policy is inefficient. The central bank undertakes quantitative easing through purchasing specified categories of monetary resources from commercial banks and other personal organizations. Thereafter, the central bank raises increases the rates of these monetary assets and reduces their productivity, and at the same time increases the fiscal base. Quantitative easing differs from the most standard system of trading short-term government bonds in order to maintain inter-bank interest rates at a fixed target rate (Eggertsson & Michael, 2003, p. 109). Expansionary financial policy to improve the economy has to do with the central bank purchasing short-term government bonds so that it can reduce short-term market rates. However, in the event interest rates approach zero, the technique fails to work. As a result, quantitative easing may apply through monetary organizations to fuel further the economy by buying assets having longer maturity as compared to short-term government bonds. The result lowers longer-term interest rates beyond the yield curve (Eggertsson & Michael, 2006, p. 54). QE can help ensure the inflation does not go below the target. Risks involve the system being more effective than expected in functioning against deflation. The result is increased inflation in the longer term, because of higher money supply. The policy may also not be effective enough incase banks fail to lend out the extra reserves. Based on the IMF and a range of economists, QE undertaken since the global financial crisis that began in 2007 to 2008 has checked some of the increased effects of the crisis. Financial experts are against the programs for aggravating wealth inequality. The finding has support from the Bank of England. b. It was not until the 2008 fiscal crisis that most central banks started using quantitative easing regularly to stimulate their economies. The use of QE enabled an increase in bank lending and at the same time encouraged expenditure. The real estate increase that began in 2007 in the US resulted into the 2008 financial crisis. Statistics indicates that the US Federal Reserve held between 700 billion US dollars and 800 billion US dollars of Treasury notes on the balance sheet prior to the crisis. In late 2008, it started buying $ 600 billion in mortgage-backed securities. At the beginning of 2009, it held 1.75 trillion US dollars in bonds from banks, mortgage-backed securities, and bank notes (Congressional Budget Office, 2013, p. 70). The amount reached a highest of 2.1 trillion in June the following year. More transactions stopped the moment the economy picked up but resumed within two months when the Fed realized that the economy was not growing as expected. After a halt in June, holdings began reducing as expected, and debts matured and expected to reduce further to 1.7 trillion by 2012. The Fed’s changed objective was to maintain holdings at $2.054 trillion. To keep the level, the Fed purchased 30 billion US dollars in 2-10 year treasury notes each month. The graph illustration below shows this: Source: Federal Reserve-H.4.1 Statistical Release for March 21, 2013 Based on the graph, it is notable that the central Reserve System, the central bank of US, trades in securities as it carries out open market operations or other programs. It creates money to buy these securities, increasing the monetary supply when it operates. At the time it begins selling securities, the money circulation reduces. Its balance sheet includes the bought securities and traces of other securities. For instance, by March 2013, the sum of Treasury and MBS was 2.87 trillion US dollar. The increment was from 476 billion US dollars at the beginning of 2009. Before 2009, the Fed did not buy MBS. The purchase started barely as an emergency measure to attain stability in the mortgage-backed securities. Fed releases information about its balance sheet in the weekly H.4.1 statistical release. According to the March 21, 2013 statistics, the balance sheet had $3.25 trillion in securities. The data of the chart came from the FRED database series (TREAST and MBST). c. Quantitative easing involves buying of MBS from banks. Primarily, the securities that the Fed buys from such lenders are perceivably toxic and unlikely to repair. In such transactions, the Fed takes the loss for the bank. It will pay cash for the securities, increasing the supply of loan able funds. Based on the loan able funds chart, an increase in the loan able funds supply decreases exact interest rates. As a result, small actual interest rates should stimulate a high amount of investment in the economy. Ultimately, since investment is an element of summative demand and GDP, an increase in investment triggers a similar increase in collective demand and GDP. The increased demand in the economy encourages employers to start hiring, hence reducing the rate of unemployment. Theoretically, all this should occur within a specific period. However, US statistics indicates that unemployment trends and GDP growth have not shown any considerable improvement. The implication of this is QE policies being unsuccessful (Eggertsson & Michael, 2003, p. 91). d. The Fed’s eccentric move to ease fiscal policy through purchasing large amounts of long-term securities weakens the US dollar just as the standard interest rate reduction does. According to research, a cheaper dollar boosts the economy since it eases selling of US goods to other countries around the world. Since quantitative easing reduces, the value of the dollar shows that Fed’s current policy tool helps the economy. e. The main reason unemployment is still high is because of lack of aggregate demand. The shortfall is the issue monetary policy should address. It is critical that the Fed continues going out of hand to help the economy recover. The Fed took some steps through extending unconventional asset purchases. Since the recovery of the economy started in mid-2009, the general growth has been slow, with the exact GDP growth averaging a feeble 2.1 percent. Undeniably, on a per capita basis, actual GDP is 1.6 percent low as compared to the state five years ago prior to the beginning of the recession. Initially, it took more than five years for per capita actual GDP to recover its level during the end of World War II. The economic progress proves halting in the job market alike. The country gained more than five million jobs from the lowest point attained three years earlier prior to the recession period (Daly, Early, Bart & Òscar, 2012a, p. 12). However, in the past 12 months, the country has been gaining just 170,000 jobs monthly on average. With growth in jobs being sluggish, the unemployment rate has reduced by less than half percent in the past one year. Demand and supply are critical factors for the financial system. Research done on the effect of demand and supply shows that Fed had an apparently optimistic evaluation of the supply state of the economy, in the final months of the 1960s and the 1970s. In particular, policymakers believed that the sustainable rate of unemployment was lower as compared to the earlier state. This misconception meant that the economy was operating below its capability, which led to policy decisions that resulted into sustained high inflation at the time. Currently, supply-side concerns explain just some of the increase in unemployment. The increase depends mainly through lack of labor demand. Before the recession, a basic approximate of the natural level of unemployment ranged between 4 and 5 percent. Empirical evidence suggests that the decline and policy response, like quantitative easing, contribute to interruption in the labor market. It resulted into the natural level of unemployment to be above the pre-recession level by about 1%. The current joblessness rates in the US are at 6%, which is consistent with the initial results. f. Investors are worried that about the Fed tapering of quantitative easing because they feel the Fed might ultimately shut off the low interest rate policy. The policy has resuscitated the economy for almost six years. It is evident from the yield on the benchmark 10 Year US Treasury as indicated in the graph below: g. Many concerns emerge on the reaction of developing economies about quantitative easing. Such countries are those through a range of economic investments, growth, and financial reforms, grow from low to middle per capita income to rich economies. The concerns relate to the manner in which globalized nature of the universal economy and practices by the US, or EU affect these economies (Chung, Jean-Philippe, David & John, 2012, p. 56). Fiscal organizations that are free to lend will move their investment into the emerging economies. Reason attributed to the higher rate of return on investment in such economies. However, it is contrary to the highly developed nations like the US. As a result, instead of the US commercial organization putting cash into US investments, the corporations will hurry investment into India because the investment will make more impact and give the company higher performance. Part 2 China uses a fixed exchange-rate system. The Chinese system is where a particular currency has a fixed value against the price of another single currency (Daly, Bart, Ayşegül & Robert, 2012b, p. 17). The system is critical in stabilizing the value of a currency against the currency pegging it. Transaction and investment in the two currency regions becomes easier and more conventional. The system is useful for small economies where external business forms a large section of their GDP. China manages this type of system by purchasing its currency on the open market. Reserves of foreign currencies in effect maintained. In the event, rates go too far below the expected rate; the government sells its currency in the market through reserves. The move places increased demand on the market and pushes the price of the currency. About the fixed exchange rate system, the central bank of China first announces a fixed exchange rate for the foreign currency and then reaches a consensus to sell the local currency at this value. Market equilibrium exchange rate is achieved, a case in which case the supply and demand become equal. To illustrate this, consider the diagram below: The above diagram uses an example of the European Central bank which may fix its exchange rate at €1 = $1. The critical value of the euro is this. Upper and lower limits for the money go beyond which disparity in the exchange rate permits. China adopts the same system to manage its money. Bibliography Chung, H, Jean-Philippe L, David, R, & John CW 2012, “Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?” Journal of Money, Credit, and Banking vol. 44 no. 1, pp. 47–82. Congressional Budget Office 2013 “The Budget and Economic Outlook: Fiscal Years 2013 to 2023.” February 5. Daly MC, Early E, Bart H, & Òscar J 2012a, “Will the Jobless Rate Drop Take a Break?” FRBSF Economic Letter, 2012-37. Daly M C, Bart H, Ayşegül Ş, & Robert V 2012b, “A Search and Matching Approach to Labor Markets: Did the Natural Rate of Unemployment Rise?” Journal of Economic Perspectives vol. 26 no. 3, pp. 3–26. Eggertsson G, & Michael, W 2003, “The Zero Bound on Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity2003-1, pp. 139–211. Eggertsson, G, & Michael W 2006, “Optimal Monetary and Fiscal Policy in a Liquidity Trap.” In NBER International Seminar on Macroeconomics 2004, eds. R. Clarida, J. Frankel, F. Giavazzi, and K. West. Cambridge, MA, MIT Press. Read More