Quantitative Easing Concept - Literature review Example

QUANTITATIVE EASING by Student’s Name Code + Course Name Professor’s Name University Name City, State Date Introduction Quantitative easing is defined as a monetary policy that central banks apply to bring down interest rates and at the same time stimulate economic growth (Plumer). Taylor and Weerapana ( 2012, p.699) on the other hand define it as a large increase in the monetary base and the Federal reserve’s balance sheet brought about by the federal bank buying of large amount of assets such as long term Treasury securities and Mortgage backed securities. The central’s bank main role is to maintain stability in the economy in terms of prices by monitoring and identifying potential vulnerabilities and problems which in turn leads to the right measures being taken. The measures ensure that the country’s financial system remains stable. Central banks set the necessary monetary policies, interest rates and controlling the supply of money (Yotov 2013, p. 63). By cutting interest rates, the central banks raise the amount of lending and other activities within the economy. People would be encouraged to spend rather than save with the low interest rates and as the interest rates go lower and lower to the near zero level, the central bank reacts by directly channeling money into the economy. This is quantitative easing and is aimed at increasing the interest rates. Central banks increase the supply of money in the economy by buying assets through commercial banks or other financial institutions using money it has created. It was first tried in Japan in the 1990s and recently in the UK and US (BBC). Debate rages on whether this monetary policy works or does not work. The study into the effectiveness of quantitative easing has come up with mixed findings with some researchers concluding that it has helped reduce yields and improved the banking and corporate sectors while others point out that it has very little effect on inflation and the state’s economic activity (Fasano-Filho and Wang 2002, p. 3). Discussion Klyuev et al (2009, p. 4) points out that advanced central banks in developed countries faced a major problem during the stages when the current economic and financial crisis was escalating. Financial systems faced stress up to 2007 with economic growth slowing down and inflation went up. The counter the financial stress, the central banks raised their liquidity providing scales and sought to control the policy interest rates. The bank of Japan was the first central bank to apply the unconventional monetary policy which targeted the amounts of excessive reserves by commercial banks by buying government securities (Klyuev et al 2009, p. 9). The introduction of this policy followed the period of zero interest policy between 1999 and 2000. The central bank used government as their main tool to arrive at their goal of current account balances that financial institutions held. The resulting impact in 2006 was that the economy showed signs of emerging from deflation (Fasano-Filho and Wang 2002, p. 3). Yotov (2013, p. 63) explains that the policy applied by the bank of Japan in 2003 involved weakening the Japanese Yen against the US dollar. This was I an attempt to increase the Japanese exports and help the country emerge from the deflation which the country had experienced for about 14 years. The bank of Japan printed over 35 trillion yen thereby tremendously increasing its supply. 320 US dollars were purchased and invested into the US treasuries. It involved creating new money, increasing its supply and at the same time ease the pressure on commercial banks. The pressure on commercial banks was caused by liquidity shortage risk due to increased spending by consumers and providing the banks with excess reserves and liquidity was aimed at increasing their lending capacity which would in turn lower the interest rates and stimulate economic growth(Yotov 2013, p. 64). Figure 1. Japan’s current account target between 2001 and 2005 From: http://www.frbsf.org/economic-research/publications/economic-letter/2006/october/did-quantitative-easing-by-the-bank-of-japan-work/ Quantitative easing has faced a number of criticisms especially in the US where it was rolled out in two phases. The financial panic in 2008 led to the federal bank in the US to carry out large scale purchases of government securities in two phases widely referred to as QE1 and QE2. The first phase saw the purchase of Mortgage backed securities worth $ 1.25 trillion and long term treasury securities worth $ 300 billion in 2009 (Taylor and Weerapana 2012, p.699). The second phase in 2010 and 2011 saw the purchase of $ 600 billion of long term treasury securities. These purchases resulted to the expansion of the federal bank’s balance sheet. Some critics argued that these enormous purchases that resulted to a wider monetary base could lead to inflation while others were of the view that the now large balance sheet would prove difficult to reduce in case the federal bank wanted to increase the interest rates. Foreign central banks on the other hand argued that the effect of the increased monetary base would spread globally thereby resulting to global; inflation. Other critics of quantitative easing were of the idea that it would do little to reduce long-term interest rates. Figure 2. Quantitative easing and the US stock market From:http://www.marquetteassociates.com/Research/ChartoftheWeekPosts/ChartoftheWeek/tabid/121/ArticleID/126/Quantitative-Easing-and-the-U-S-Stock-Market.aspx Quantitative easing would not necessarily lower the interest rates when they hit zero, but it may stimulate the economy since its focus is on stimulating the economy rather than lowering the interest rates. By increasing the money supply in an economy, people would be encouraged to spend and the large amounts of reserves and money may be used to purchase higher amounts of good and services directly (Taylor and Weerapana 2012, p.699). Basic economic laws of demand and supply stipulate that increased demand of goods and services leads to an increase in their relative prices and in the end result to inflation. Inflation is beneficial to the economy especially when it is moderate (Around 2%). Not only does it allow adjustment of prices and wages, but it also boosts growth. Large amounts of reserves and money will therefore stimulate the economy. In addition to that, some economists are of the view that increasing reserves or money could lead to lower interest rates on a number of securities (Taylor and Weerapana 2012, p.699). Does QE really work? This is the fundamental question this paper is trying to address. As earlier stated, some economists point out that it is beneficial to the economy and achieves its aim, which is t stimulate the economy, while others are of the view that it does little to lower the inflation rate and result to economic growth. They argue that if improperly used, it could result to undesired levels of inflation. In Addition to that, it could result to the value of a country’s currency falling. This was the case with Zimbabwe which applied a policy similar in nature to quantitative easing. The country’s central bank printed a lot of money and this resulted to hyperinflation and the value of the currency to drastically fall. EU states are not allowed to print money to meet their public deficits as the case was with Zimbabwe (BBC). Quantitative easing only runs the risk of leading the country into hyperinflation only if the printed money is used for other purposes other than easing credit markets. Studies have shown that it actually resulted in raising economic activities to some extent and that the slow pace of economic stimulation using QE is attributed to the cautious approach central banks use with regard to this policy (The economist). It not yet clear whether quantitative easing worked for the US economy but studies and reports show that QE1 was influential in helping the country avert the risk of falling into a giant depression following the financial panic of 2008 ( Plummer). Not only did it boost the confidence in quantitative easing, but it also resulted to a steady rise in inflation and a rise in the country’s economic activities. It is also important to note the impact QE has had in the UK whose central bank started using the policy in 2009. It resulted to the pushing up of the prices of government bonds which in turn result to lower yields to investors. Economists in the UK have pointed out Quantitative easing as the main reason why company pension scheme deficits in the UK have gone up. The reason for this is that the cost involved in paying pensions from salary schemes is calculated while assuming that all assets were invested in bonds. A drop in the yields of bonds results to a rise in the stock of assets that is needed to generate a similar level of pension (BBC). It is reported that the deficit in the UK pension scheme reached £ 312 in 2012 and that if this goes on, employers will have to pay the deficit off thereby presenting them with a large bill to clear. However, the first phase of QE in the UK that involved the purchase of securities worth £ 200 in 2009 resulted to an increase in the economic output by 1.5% to 2% annually (BBC). This proved the policy’s significance and even one economist is quoted stating that without it, the UK could have fallen into a credit-laden depression (BBC). Rochon and Olawoye (2012, p 12) point out that monetary policies have adapted the modern Keynesian doctrine where central banks have a say when it comes to stimulating the economy. They point out that Quantitative easing has had a significant impact on the macro economy as stated by Ben Bernanke, the Federal Reserve chairman, in 2011 during the Joint Economic Committee. By changing reserves through open market operations, central banks impact the short term nominal interest rates. The demand of money in an economy negatively depends on the rate of nominal interest and by changing the interestrate; the central banks are able to change the quantity of money circulating in an economy. When there is a change in the quantity of money supplied, the interest rates go down but when the interest rates reach zero, the central banks utilize quantitative easing in attempts to reduce the rates(Taylor and Weerapana 2012, p.699). Central banks use a number of quantitative easing tools that include lending money to commercial banks, purchasing government debts and buying the assets of commercial banks. Yotov also points out that quantitative easing as a policy can be viewed in a number of circles as having a negative impact on currencies as it results to an increase in the supply of money in an economy which in turn results to inflation and devaluation of a country’s currency. The announcement of the EQ in the US in March 2009 saw a steep US dollar sell off with the EUR gaining more the 500 PIPs against the dollar in one trading session. However, QE can be used to create inflation in order to prevent the occurrence of deflationary periods in an economy and result to a faster pace of economic recovery after a long period of recession (Yotov 2013, p. 64). This was the case with Japan which was able to come out of 14 year old recession period through the application of this policy. Fasano-Filho and Wang (2002, p.3) access the impact quantitative easing has had on the Japanese economy since the policy was enacted in 2001. They point out that monetary easing has succeeded in supporting economic activity and to some extent has also supported inflation. However, shocks to monetary policy variables have resulted to a small variation in output and inflation. Evidence in Japan’s case have shown that the policy has been able to reduce yields and that during the period between 2001-2006 when the quantitative easing was in place, the Japanese CABs improved from 5 trillion Yens to about 36 trillion Yens in 2004 when it was at the peak. It later declined at the end if the period (Fasano-Filho and Wang 2002, p.3). This clearly points out the significant role the policy played in the growth of the Japanese economy within the stated period. To meet its aim, the Bank of Japan utilized long term government bonds to a greater extent. Quantitative easing did not only aid in creation of a much more accommodating atmosphere for corporate financing, but it also led to an improved lending attitude in financial institutions (Fasano-Filho and Wang 2002, p.4). Quantitative easing had a small impact on inflation and economic activity in Japan’s case. This, according to financial experts, was due to poor credit channels that became impaired after the financial crisis of the 1990s. The crisis resulted to a weakened banking system. In addition to that, the corporate deleveraging also played a role on the policy’s low impact on inflation and economic activity (Fasano-Filho and Wang 2002, p.4). Apart from the Japanese case, studies on other countries have shown that QE has been effective in preventing inflation and in boosting economic growth. Chung et all ( 2011) used the FRB/US model and were able to find out that unemployment was lowered by 1.5% points thorough the holding of securities by federal reserves since 2008 when the US enacted the policy. Long term securities purchases have minimal credit risks and show the desire of central banks to lower interest rates on the long-term and it is also accommodative to the investors. Increasing the bank reserves through the central bank is easy to implement as it follows the already set channels of credit creation (Klyuev et al 2009, p. 10). The US federal banks approach in 1932 that involved the purchase of large scale treasury bonds is considered by some economist as a perfect prove that quantitative can actually work. The approach the federal bank in US applied after the 1929 Great Crash and banking crisis is credited for lifting the economy from the great depression by keeping yields low. In Japans case, QE was not as effective as expected with pundits pointing out that the efforts were late (Curtis). However, evidence has shown that it actually works and has achieved its aim of stimulating economic growth in a number of countries such as UK and US Conclusion Quantitative easing is a monetary policy that central banks apply to bring down interest rates and at the same time stimulate economic growth. This is brought about by the federal bank buying of large amount of assets such as long term Treasury securities and Mortgage backed securities. Debate has been ongoing whether the policy works or does not work but evidence in a number of countries such as the UK, US and Japan have shown that it has stimulated economic activity and impacted inflation to some extent. Central banks increase the supply of money in the economy by buying assets through commercial banks or other financial institutions using money it has created and this results to reduce yields and improved the banking and corporate sectors. Some economists argue that it has very little effect on inflation and the state’s economic activity. Apart from that, they argue that the enormous purchases that result to a wider monetary base could lead to hyperinflation and that the now large balance sheet would prove difficult to reduce in case the federal bank wanted to increase the interest rates. However, studies in the UK, Japan and US have shown that the approach is effective. References BBC News. 2014. What is quantitative easing? [online] Available at: http://www.bbc.com/news/business-15198789 [Accessed: 15 Mar 2014]. Chung, H. and others, 2011.Have we underestimated the Likelihood and Severity of Zero Lower Bound Events? Federal Reserve Bank of San Francisco, Working Paper Series, No. 2011–01. Curtis, P. 2011. Reality check: does quantitative easing work? [online] Available at: http://www.theguardian.com/politics/reality-check-with-polly-curtis/2011/oct/06/reality-check-does-quantitative-easing-work [Accessed: 15 Mar 2014]. Fasano-Filho, U., Fasano-Filho, U. and Wang, Q. 2002.Bank of Japan's Quantitative and Credit Easing. Washington, D.C.: International Monetary Fund. Klyuev, V., De Imus, P. and Srinivasan, K. 2009.Unconventional choices for unconventional times. [Washington, D.C.]: International Monetary Fund. Plumer, B. 2012.QE3: What is quantitative easing? And will it help the economy? [online] Available at: http://www.washingtonpost.com/blogs/wonkblog/wp/2012/09/13/qe3-what-is-quantitative-easing-and-will-it-help-the-economy/ [Accessed: 15 Mar 2014]. Rochon, L. and Olawoye, S. '. 2012. Monetary policy and central banking. Cheltenham: Edward Elgar. Taylor, J. B. and Weerapana, A. 2012.Principles of economics. Mason, OH: South-Western Cengage Learning. The Economist. 2014. What is quantitative easing? [online] Available at: http://www.economist.com/blogs/economist-explains/2014/01/economist-explains-7 [Accessed: 15 Mar 2014]. Yotov, I. 2013. The quarter’s theory. Hoboken, N.J.: Wiley. Read More