Economic Impact of Quantitative Easing in the United States - Essay Example

Introduction Quantitative easing is a method that central banks used to increase lending from financial s. Itis the last resort when central banks want to boost the economy after a serious relapse. Quantitative easing refers to a situation where the government buys government securities and other secretaries to help lower the interest rates and increase the supply of money. Quantitative easing has been known to increase the money supply by increasing the amount money available to financial institutions. The ultimate effect is increased lending and liquidity. Typically, a central bank would consider using quantitative easing when the short-term interest rates are fast approaching zero. It does not involve printing of new banknotes. Low-interest rates can lead to what is termed as a “liquidity trap”, which makes monetary policy very ineffective. A liquidity trap conceives a situation where consumers will opt to keep their money in savings with the hope that the interest rates will rise. They will shy away from purchasing bonds. Therefore, conventional monetary policy methods cannot work. Bonds are inversely related to interest rates. Therefore, consumers will shy away from buying bonds because their prices will not rise. In late 2008, the Federal Reserve introduced quantitative easing in a bid to help the economic recover the global financial crisis of 2007/2008. The method had three rounds of purchasing, which are QE1, QE2, and QE3. Quantitative easing effective in stabilizing US financial markets, reducing the overall risk and conceived some positive indicators. Some of these indicators include GDP growth, reduced unemployment levels and an inflation rate below the target. However, the growth of GDP has not been high as expected and the unemployment rates have remained high. It is apparent the US economy is not performing at its best. In effect, I am inclined to believe that an alternative measure like an expansionary fiscal policy would have been more effective than quantitative easing. Interest Rates and Liquidity Trap. According to the economist John Maynard Keynes, individuals prefer liquidity because of three motives, which are precaution, speculative and transaction. Liquidity refers to the cash. Under transaction motive, individuals and firms participate in many transactions in a single day. Therefore, they would want to hold cash to purchase goods and services. Second, individuals and firms will prefer liquidity because they want to keep some money for emergencies and accidents. The amount of money kept aside as a precaution depends on the size of income, farsightedness and the nature of the person. In some cases, households and firms want to keep liquid cash because they anticipate changes price of securities and bonds. One should note that a rise in the price of bonds is expected individuals will not prefer liquidity; they will opt to purchase the bonds. The opposite effect is borne when the price of bond and securities are expected to fall. They will keep the cash to buy bonds and securities when the prices fall. Therefore, it is apparent that liquidity preference is high when the interest rates are low. The speculative motive is the one that is affected by monetary policy. The supply of money is not affected by any person. It depends on the government and policies developed by the central bank. Therefore, the supply of money has a perfect inelastic curve. The demand for money and supply of money interact to determine the prevailing interest rates. The following curve shows the how interest rates are determined. Rate of interest Ms i LP Qm LP is the curve that shows demand for money and Ms is the supply of money. The interaction of LP and Ms gives rise to an equilibrium interest rate i. If the interest rate rise above i the supply of money will be surpass demand for money, which will pull down the interest rate. The exact opposite if the level of interest rate goes below i. Therefore, monetary policy can either influence the supply of money or allow the rate of interest to be decided by money demand. Alternatively, the authorities fix the rate of interest and set the supply of money at a level that will help maintain that rate of interest. Liquidity trap occurs when the changes in the money supply cannot influence rate of interest. Therefore, monetary policy cannot be used to influence things live investment and consumption. The following curve shows how liquidity trap occurs. Zero lower bound occur when the interest is near zero. It is shown in the above curve. The IS-LM curve shows the interaction between interest rates and the real output. It helps explain how monetary policy influences supply of money and overall demand for goods and services Image Courtesy of Urbanomics. The IS (investment/saving) curve shows the variation between income and expenditure. It incorporates the interest rates in the market. The LM (liquidity preference/money supply equilibrium) shows the money available for investment purposes. The decrease in the interest rates leads to increase in investments, which expands the economy, and income levels will rise. In effect, the money available for spending will also increase. Central banks can lower interest rates to encourage spending and investment, which will eventually raise employment levels. The central bank has to lower interest rates to encourage individuals to prefer liquidity. The increase in the national income (Y) will increase spending and high demand for money. It will cause a shift in the LM curve. The fiscal policy influences the IS-LM curve by influencing the levels of spending. The IS curve will be shifted by anything that influences consumption, investments and government spending. Increased government spending will raise the demand for goods and services and push the IS curve to the right. The effect is an increased national income (Y) and aggregate demand. Automatically, the rate of interest will rise to create an equilibrium between the funds available for loan and preference for liquidity Increase in interest rates will negatively affect private consumption and investment. It will put downward pressure on the overall economic output. At this point, an increase in government spending will cause inflation, which will cause the LM curve to shift inwards. The result will be an increase in interest rates. These two factors will discourage economic growth. The same thing will happen when monetary policy increases money supply. The LM curve will be pushed downwards, which will lower interest rates, encourage investments and consumption. It will also increase the national income. External shocks can influence savings and liquidity preferences. However, the prices/ wages tend to return to the real LM curve (money supply curve). It implies long-term effects on monetary policy are very low. The following curve shows how the problem of zero bound affects monetary policy. It leads to a liquidity trap. Image Courtesy of Urbanomics The Zero Lower Bound problem prompted the US government to use quantitative easing to stimulate economic growth. The government participated in buying securities backed by mortgages. The purchase was done in three rounds namely QE1, QE2, and QE3. The purchasing helped in stimulating economic growth and prevented a further slump during the recession. In effect, the Federal Reserve has kept the interest rates low enough to encourage investments and borrowing. The financial market has been stabilized. In addition, quantitative easing has helped the Federal Reserve to keep the inflation rate at a relatively low level. The rate of inflation has stayed below the target. Quantitative easing is responsible for the significant economic growth that the US economy experienced in 2010. Regardless, it is necessary to note that the GDP growth rate has not been fast enough. The unemployment levels have also remained stubbornly high. Possibly, it is because the GDP growth has not been fast enough to raise employment levels. Quantitative easing comes with a myriad of risks that can comprise the economic stability in the future. First, the threat of inflation is always present when quantitative easing is used to stimulate economic growth. Second, low-interest rates encourage investments and spending. People are likely to engage in highly risky investments, which might lead to another economic recession. In addition, low-interest rates lead to a massive transfer of wealth. Third, quantitative easing does offer permanent solutions to the economic problem. It offers temporary solutions that might be become useless in the long term. It is my belief that that the expansionary fiscal policy would form a better solution. It entails the use of tax cuts and government spending to boost the economy. The aim is to increase the money supply or fight inflation. Increased government spending, consumption, exports, and investments increase the aggregate demand, which leads to economic growth. Low-interest rates will make firms and households borrow and invest. In effect, the aggregate demand will increase. Therefore, the government can opt to stimulate the economy by implementing tax cuts and increase government spending to encourage investment and borrowing. It is fact that expansionary policy can lead to a budget deficit because of heavy spending and tax cuts. However, I believe its effects will be less detrimental compared to the effects of quantitative easing. Conclusion It is easy to be duped that quantitative easing has put the US economy on a better path to recovery. However, a closer analysis reveals the economy should be at a better state than it is now. The paper asserts that an alternative solution would have worked much better than quantitative easing. Expansionary policy would have been much better than quantitative easing. It is imperative for US legislators to notice the negative effects of quantitative easing and deal with them before they grow from worse to worst. Works Cited Arnold, R. A. (2010). Macroeconomics. Mason, OH: Cengage Learning, South-Western. Hausken, Kjell, and Mthuli Ncube. Quantitative Easing and Its Impact in the Us, Japan, the UK and Europe. New York, NY: Imprint: Springer, 2013. Internet resource. Vroey, M ..., & Hoover, K. D. (2004). The IS-LM model: Its rise, fall, and strange persistence. Durham, N.C: Duke University Press. Read More