Impact of Quantitative Easing on Money Market and Interest Rate - Assignment Example

Economics Student Inserts Name Customer Inserts Tutor’s Name 25th September, 2014 Assessment 2 Part 1 a) What is QE? This is a technique utilized by central banks or the Federal Reserve banks in lowering long term interest rates through the creation of demand for treasury bonds or notes or mortgage backed securities. This technique is undertaken by increased investment in these instruments by these central banks and therefore reducing interest rates to rates close to zero (Bauer 2011, p. 17). b) Impact of QE on Money market & Interest rate in US since 2008? QE has had a big impact on the money market since it has assisted in increasing the supply on money in the country. This is because QE has a direct effect of lowering long-term interest rates and therefore consumers and organizations feel liberated to apply for loans and thus there will be an increase of money supply in the economy (Gagnon 2011, pp. 43-49). c) Has QE had an impact on Loanable funds? QE has an effect on long term interest rates and therefore, there will be phenomena whereby loans and loanble funds will be cheaper for consumers and corporate organizations. During the financial crisis of 2008 and after, the US government implemented QE to ensure that credit becomes cheaper for corporate organizations to pay debts and encourage borrowing (Yotov 2009). d) What effect did QE have on the American Dollar? QE has a large effect on weakening the US Dollar since the QE has a great on the availability of money in the market. Due to the low interest regime brought about by QE, the US dollar has been on downward trend and the currency has lost as much as 17% in the last 3 years (Moosa 2014). This is best shown by the figure 1 below. Figure 1: showing inflation levels expected due to QE e) Current state of American economy based on aggregate demand and supply and effects of QE on aggregate demand? Demand and supply depends on a lot of factors such as the state of the economy, inflation and price index for good and supplies. Due to weakening of the US dollar and in the increased inflation levels in the country, aggregate demand has appreciated in last 4 years for goods and services (Klyuev 2009). f) Why are investors worried about the Federal Reserve tapering of QE? Investors are worried by the Federal Reserve’s decision to taper with QE due to changes in the US economy. The slow and improved economic growth in the US has encouraged the Federal Reserve to effectively reduce QE and stop the scheme in the first quarter of 2015. However, this move has made investors jittery since improved economic figures do not necessarily reflect on better unemployment figures or increased domestic demand in the US. Investors are of the view that QE should be extended to ensure organizations are cushioned from higher interest rates in the recovery period (Moosa 2014). Moreover, the move by the Federal Reserve in QE tapering contributes to hike in the price of US dollars and thus this might make the US exports and trade expensive for investors (Yotov 2009). g) What effect did QE have on emerging economies? The move by the Federal Reserve to taper with QE has a large effect of decline on emerging economies. This is because these countries were large recipients of QE funds and excess liquidity in the market. As a result, most of these economies’ GDP will shrink by between 2.8 and 3.1% over the next 3 years. However, these negative impacts will be limited as the global and the US economy are set for recovery in the next 3 to 5 years (Moosa 2014). Part 2 China’s economy and exports have been on the growth trajectory over the last one decade and a half. This has been mainly attributed towards the stability of the Chinese Renminbi against major currencies such as the US Dollar. China has for a long time been using a fixed exchange rate to control the exchange rate of its currency against major global currencies (Suranovic 2013). However, the Chinese changed its strategy and decided to adopt a floating exchange regime albeit controlled by the People’s Bank of China (PBC). China undertook exchange rate reforms in the year 2005 and since then its currency has appreciated over 30%. This appreciation is massive in relation to other major global currencies (McKinnon 2005). Therefore, the exchange rate reform instituted by the PBC has had an effect on the appreciation of the Renminbi. However, some analysts argue that the floating exchange rate reform by the PBC is not free from manipulation from PBC and market forces are not allowed to determine the value of the Renminbi (Funke 2008, pp. 1587-1594). The PBC has for a long period of time made use of the UD Dollar to decide and manage exchange rate policy for the country. As a result, the fluctuations of the Renminbi against the US dollar were marked with control and the exchange rate changes were modest. For instance, from the year 1996 to the year 2005, the Renminbi remained steady against the US dollar (Yellen 2010). Fluctuations of the Renminbi were only noticed from the year 2005 onwards as shown by the diagrams below; Figure 2: showing the exchange rate comparison of the USD against the Renminbi From the diagram we, notice that the Renminbi maintained a steady exchange rate level between 1996 and the year 2005. Analysts attribute this to a managed exchange rate policy by the PBC which maintained the fluctuations at between +0.15% or -0.15% and therefore the major currencies such as the US dollar could not change against the Renminbi with high fluctuation levels. From the year 2005 all through the year 2008, the managed exchange rate of the Chinese Renminbi was adjusted to reflect the changes in the exchange rate reforms (Martins 2007, p. 96). Since the Chinese Renminbi was pegged against the US dollar, the country adjusted fluctuations to about 1% in increases or decreases of the currency against the US dollar. As a result, the Chinese Renminbi appreciated impressively against the US dollar and this reflects the willingness of the PBC in conducting exchange rate reforms in relation to its economy (Suranovic 2013). Even though many nations were impacted by the global economic crisis, the Chinese government continued with its exchange rate reforms over the period after the financial crisis hit other countries (Zhang 2009). Prior to 2008 the PBC used to purchase large amounts of US dollar to stabilise the Chinese Renminbi, this policy has gradually changed. For instance, the PBC used to purchase around $ 100 billion every quarter to ensure the Renminbi steadied against the US dollar and other major global currencies (Harvey 2007). This policy was mainly targeted at ensuring that the global economic crisis does not affect Chinese producers and in effect mess with the Chinese economy. However, from the second quarter of 2011, there has been a policy shift that has allowed the country to have a larger managed floating exchange rate that allows the Chinese Renminbi to shift in a prudent manner (Martins 2007, pp. 72-79). This is because the PBC has reduced purchase of assets and reduced its reserves by reducing the significant purchases from around $ 100 billion per every quarter to around $ 2.5 billion for every quarter (Bodestein 2009). This is well reflected by the changes in exchange rate between the Euro and the Renminbi over the period as shown by figure 2 below. Figure 3: showing the exchange rate comparison of the Euro against the Renminbi The figure above indicates that the Chinese Renminbi has been fluctuating against the Euro in favour of the Euro. The appreciation of the Chinese Renminbi has been reflected on all major currencies in the world and this phenomenon is expected to continue into the future. The actions of the PBC in terms of control over its currency controls has been criticised by many observers. But China maintains these controls to ensure the country’s economy or exchange rates are affected negatively by massive changes in the exchange rates. Maintaining steady exchange rates by of the Renminbi by the PBC has allowed China’s economy to grow globally and ensure the country earns massive investments in the country and growth in exports (Suranovic 2013). For instance, the Chinese GDP’s contribution to the global economy has grown massively from 1.7% to around 7.3% between the periods 1980 to 2008. This has ensured the purchasing power of the country to contribute around 11.3% of the global economy. Due to the adoption of managed floating exchange regime in China, the country has witnessed changes in the aggregate demand and inflation in the country. China has witnessed growth of exports in the last 2 decades the country and this has had a positive impact on aggregate demand. Inflation in the country has also grown tremendously as reflected by the retail prices of items over a period of 14 years from 1983 to 1997 as shown by the diagram below. Figure 4: showing inflation levels in China over a selected period. The retail prices of items indicated above were during the period when China had a fixed exchange rate regime and therefore the country witnessed erratic changes in demand and inflation. The aggregate demand and inflation in China increased considerably under the managed floating exchange rate regime introduced by China from the year 2005 and onwards. This is because the demand for Chinese good soared in the global market and thus the supply of money in the country also increased by a great percentage (Pilkington 2013). Several factors have contributed to the growth and increased inflation in China such as; a) Money supply: China has over the last decade had a lot of money in supply due to its well developed and grown export market which has contributed to increased supply in money. b) Increased government spending: The Chinese government was forced to come up with a fiscal stimulus package to ensure aggregate demand and inflation is tamed. This was in response to the global financial crisis of 2008 and there was increased government spending leading to growth in the Chinese in absorbing the financial crisis shocks of the period (Suranovic 2013). c) Increased price global price levels: The global economy experienced upsurge in commodity prices when phenomenal export and trade grew. However, these gains were eroded by the global financial crisis of 2008. But retail and other household prices still remained high contributing to inflation. Aggregate demand increases in China could be attributed to growth of enterprises and the increased household incomes boosted by higher wages and government transfers which was effected as part of the fiscal stimulus package by the Chinese government (Pilkington 2013). The increased aggregate demand is best reflected by the data captured in the figure 4 below. Figure 5: showing aggregate demand and inflation for China, 2009/2010 Although China was affected by the financial crisis of 2008, the effect on its economy in terms of increased inflation and aggregate demand was not so huge. This because the government decided to launch a fiscal stimulus package equivalent to 2.9% of the country’s GDP and this had a tremendous effect on stabilizing aggregate demand and ensuring inflation figures were maintained as shown in the figure above. Experts are of the opinion that the floating exchange rate policy adopted by China will not dampen export demand for Chinese goods (Pilkington 2013). Since, Chinese goods are still attractive in the global economy and therefore, aggregate demand and inflation levels will remain higher in China for a long period of time. References Bauer, M and Rudebusch, G 2011, "Signals from Unconventional Monetary Policy." Federal Reserve Bank of San Francisco Economic Letter, Vol. 1, pp. 17-22. Bodestein, M, Erceg C and Guerrieri, L 2009, “The Effects of Foreign Shocks when U.S. Interest Rates are at Zero.” International Finance Discussion Paper 983. Washington, DC, United States: Federal Reserve Board. Funke, Michael and Marc Gronwald 2008, “The Undisclosed Renminbi Basket: Are the Markets Telling Us Something about Where the Renminbi-US Dollar Exchange Rate is Going?”, World Economy, Vol. 31(12), pp. 1581-1598. Gagnon, J, Raskin, M, Remache, J and Sack, B 2011, "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" Federal Reserve Bank of New York Economic Policy Review, Vol. 17(1), pp. 41-59. Harvey, F 2007, Forecasting, Structural Time Series Models and the Kalman Filter, Cambridge: Cambridge University Press. Klyuev, V, Imus, P and Srinivasan, K 2009, Unconventional Choices for Unconventional Times Credit and Quantitative Easing in Advanced Economies. New York, NY: International Monetary Fund. Kreinin, M 2010, International Economics: A Policy Approach, Boston, MA: Pearson Learning Solutions. Martins, J, Scarpetta, S and Pilat, D 2007, “Mark-up Pricing, Market Structure and the Business Cycle.” OECD Economic Studies, vol. 27(2), pp. 71-106. 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