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Evaluate the reasons for and effect of quantitative easing (QE) as a monetary
policy measure.
IF2201 Monetary Economics
Anjali Shah: 110056404 Rizwaan Khan: 110015300 Anna Panayi: 110002872 Elizabeth Tanya Masiyiwa: 110014205 Shabir Balani: 100009626 Taylor Nisbet: Exchange
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Contents Table MONETARY POLICY........................................................................................................................... 2 AGGREGATE DEMAND ..................................................................................................................... 4 QUANTITATIVE EASING.................................................................................................................. 5 THE EFFECTS OF QUANTITATIVE EASING............................................................................. 7 How the UK economy applied Quantitative easing.............................................................. 9 Conclusion........................................................................................................................................... 10 Bibliography....................................................................................................................................... 12
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In the current economic environment in Britain, the government is trying to find ways through policy and legislation to effectively achieve economic stability. One of the main instruments used to do so is Monetary Policy; which is a demand-‐side policy used by central banks to influence macroeconomic conditions. The following report will define monetary policy as an instrument used by central banks to achieve specific economic objectives and evaluate the reasons for the use of Quantitative Easing (QE) as a policy measure. QE has been extensively used by three of the world’s dominant economies -‐ Japan, the United States and the United Kingdom. This report will evaluate the positive and negative effects of quantitative easing specifically to the UK economy. MONETARY POLICY Monetary Policy is an instrument used by the central banks to control the supply of money in the economy. It is implemented through open market operations, setting the discount rate and changes in reserve requirements. The most effective tool available is the changing of the rate of interest to achieve economic objectives. Through monetary policy, the Bank of England aims to achieve economic growth and monetary stability. These tools can be used for either expansionary or contractionary monetary policy to boost or reduce the money supply respectively. When using monetary policy, time lags have to be taken into consideration; typically when policy is employed, its effects on GDP would not become evident for 5 quarters and its effects on inflation for 8 quarters. In the UK the Monetary Policy Committee (MPC) makes many key decisions concerning monetary policy. This committee is comprised of 9 highly qualified members, all independently accountable for their decisions to keep Britain’s economy moving in the right direction. The MPC’s main functions are to maintain a stable economic growth and a low rate of inflation. This is achieved by setting the official interest rate, which enables the economy to meet its inflation target. This interest rate affects all other market rates, including mortgage rates and the rates that banks charge to businesses as well as consumers. The importance of this mechanism and its sensitivity complicates the decisions made by the MPC, as its affects are not isolated. The rate is therefore adjusted on a monthly basis to reflect these requirements. Expansionary monetary policy is used when projected inflation levels are below the government set targets. The MPC lowers interest rates with the intention of manipulating money demand and money supply, to affect aggregate expenditure and demand as illustrated with the diagrams below. By lowering the rate of interest, the quantity of money demanded increases. Money is withdrawn from savings accounts and other long-‐term investments to meet money demand. This additional money is then invested on a shorter-‐term basis, resulting in an outwards push in aggregate expenditure, in turn influencing aggregate demand, as illustrated below.
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Demonstrated in Figure 11 (DineshBakshi) the increase in expenditure has generated a rise of aggregate expenditure, which has pushed the level of GDP, being the number of final goods and services produced in a country in a year, outwards. This ultimately leads to a new equilibrium point of output at which prices are higher. Contractionary policy works in the opposite way, where in the MPC raises interest rates with the intention of lowering levels of projected inflation so to meet government set targets. The higher interest rate discourages consumption with the incentive of being able to receive a higher amount of money in the future. This therefore contracts money supply, as people are putting their money into accounts and long-‐term investments. Ultimately, GDP contracts due to a fall in aggregate demand, leading to lower prices as people are no longer looking to spend in the short term. 1 http://www.dineshbakshi.com/ib-‐economics/macroeconomics/165-‐revision-‐notes/1899-‐monetary-‐policy-‐and-‐the-‐economy
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AGGREGATE DEMAND Monetary policy plays a dominant role in controlling aggregate demand. In order to achieve this it has to have an effect on one or more of the components of aggregate demand, the components being:
AD = C + I + G + (X – M) When expansion in the economy is required, the base rate is lowered in effect shifting Aggregate Demand and Inflation rates. The effects are illustrated in Figure 3. Analysis of the Effects of a Decrease in Interest Rates on the components of AD The effect of the increase in aggregate demand is a shift in the AD curve to the right from AD to AD2 as shown in Figure 32 (EconomicsHelp.org, 2011). This forms a new equilibrium in the economy. In turn, economic output increases from Y1 to Y2 resulting in a decrease in unemployment. The shift in aggregate demand also has a negative economic effect. After the rightward shift in the AD curve, the price level rises from P1 to P2; this may cause an increase in inflation, which offsets the results effect of lowering the interest rate. Consumption and investment will decrease with a higher inflation rate because higher prices reduce consumer and investor confidence.
2 http://www.economicshelp.org/macroeconomics/monetary-‐policy/effect-‐raising-‐interest-‐rates.html
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The graph above shows the UK’s annual rate of interest from January 2001 to June 2012. Through monetary policy the government reduced interest rates to historically low figures in order to reduce the negative impacts of the 2008 economic downturn. The Monetary Policy Committee has set interest rates at 0.5%; this rate has not changed for the last three years. According to Keynes’s macroeconomic theories, a liquidity trap can occur when interest rates have become so close to zero, that the use of monetary policy to decrease interest rates further will have no effect on stimulating the economy. Therefore the MPC had to take unconventional methods to stimulate the economy, which was quantitative easing. Therefore one could argue quantitative easing is only used when all traditional methods have been exhausted and are no longer applicable. QUANTITATIVE EASING Quantitative easing is a monetary policy measure designed to inject money directly into the economy. It was introduced due to the low levels of spending in the economy, as a consequence of the financial crisis as well as the UK falling into a liquidity trap. The Bank of England, through the MPC, created money electronically by purchasing financial assets comprised mostly of government bonds. These assets are purchased from insurance companies, pension funds, high street banks and non-‐bank firms. Through quantitative easing, the MPC can increase the level of spending in the economy and stimulate economic growth. As the Bank of England purchases bonds, their price increases and their yield decreases. Holding money has an opportunity cost; capital could be invested elsewhere where the investor could earn a higher rate of interest. As the government purchases these securities, the price rises because investors have no incentive to hold the capital they receive, so the yield decreases. This can be illustrated through the Baumol-‐Tobin model, which provides a microeconomic explanation of this analysis. The model demonstrates how the demand for money, for transactional purposes, is sensitive to the rate of interest. As
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interest rates rise, the opportunity cost of holding capital increases. In turn, the expected return on other investments such as corporate bonds, stocks and commodities will increase, reducing the number of transactions. In contrast, as interest rates decrease, investors have more of an incentive to hold money for transactional purposes and the expected return on other investments fall. This has two distinct effects on the institutions from which these bonds are purchased. Firstly, the purchase of bonds gives banks and other financial institutions more liquidity and secondly, the sale of other financial assets increases, which increases their value and decreases their yield. The Bank of England aims to increase the capital held by private sector institutions. Greater liquidity gives banks the ability to lend more capital to households and businesses. For households, they have a higher purchasing power; this raises the level of spending increasing aggregate demand through higher consumption. Lower yields also reduce the cost of borrowing. Consequently, firms have the ability to purchase real investment assets to increase output and generate larger profits. Creating money electronically is one of the most innovative characteristics of quantitative easing. By merely printing, the central bank would increase the supply of money in the economy. But with no corresponding increase in demand, this would push up prices, resulting in inflation. Through QE the central bank can channel funds where they are most effective, resulting in an improvement in liquidity and an increase in reserves of the banking sector. These are necessary for Britain’s economic recovery after the failure in the banking system. Quantitative easing can be interpreted with the equation of exchange; as government purchase financial securities the quantity of money increases (M). This in turn increases the number of transactions (V) resulting in an increase in the level of output (Y) where inflation is at a constant rate of growth (P). The MPC aims to achieve a higher level of spending to boost Britain’s economic growth through quantitative easing.
M + V = P + Y3 Increasing aggregate demand through higher bank reserves may not be effective. The financial crisis showed how banks were now lending to more risky lenders who were likely to default in order to increase the number of loans granted. Granting more loans could be limited because of credit rationing. Greater capital reserves can be explained using the Quantity Theory of Money; this observes GDP and not the number of transactions as opposed to the equation of exchange explained above. The principle of this theory states that there is a direct relationship between the quantity of money in the economy and the price level of goods and services in the economy. Because the Bank of England creates money that is fed into the economy through private sector institutions, the quantity of money in the economy rises resulting in a corresponding rise in GDP. A rise in GDP is a good sign for growth and a recovering economy I also has social effects such as a rise employment. 3 The equation of exchange
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THE EFFECTS OF QUANTITATIVE EASING Quantitative Easing is implemented with the intention of stimulating growth within a weakened economy. A lower interest rate is one of the positive outcomes from implementing quantitative easing. Quantitative easing drives down interest rates, so that banks can now borrow at 0.5%. As a result, banks loan money to the public at a lower interest rate because of this increase in the money supply. The reason banks are able to lend at lower rates of interest is because the cost of receiving funds from the Central Bank is also lower. Lower interest rates make it more appealing to start borrowing money from the banks again, resulting in increased consumer spending to heighten the RGDP4. One of the biggest concerns of working with quantitative easing is its effect on inflation. By increasing the money supply in the economy, the Bank of England reduces the purchasing value of the currency. The target for the Bank of England is to keep the inflation rate at 2%. This target has not been met, however inflation in general is decreasing and on progress to meet targets. “The annual inflation rate as measured by the Consumer Prices Index fell to 2.4% in June, from 2.8% in May.”5 (Flanders, 2012) The graph about shows the percentage changes in inflation from the beginning of 2001 to the end of September 2012. The rate of inflation had been on a steady increase until it reached a peak of 5.2% in September 2008. As a consequence of the global economic downturn, inflation began to fall alarmingly in the third quarter of 2008. In March 2009, the Bank of England announced the first round of purchases through quantitative easing and cut the bank rate to 0.5% simultaneously. Since quantitative easing was first applied, the government’s target inflation rate of 2% has not been met but the rate of inflation has been falling. Now that quantitative easing has decreased, the inflation rate is starting to decline to the Bank of England’s target of 2%.
4 Real GDP 5 http://www.bbc.co.uk/news/business-‐18867248
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Quantitative easing has proven to be a tool necessary for the stimulation of a suffering economy. However it has had adverse effects on annuities, pension funds and inflation. Annuities and pension schemes have suffered the most immediate effects as a result of quantitative easing, due to the negative correlation between gilts prices and their yield. Annuity rates have been in a rapid downfall since the collapse of the economy and with quantitative easing in effect, it has only made the situation worse. As the government is purchasing bonds from banking institutions, insurance companies and pension funds, the bonds that remain in the market and those held by these institutions increase in price but their yields reduced. Reduced yields lower the annuity a pensioner can buy. “Annuity rates have fallen from 7.855% for a level income for a 65-‐year-‐old man in 2008 to 5.743% in 2012, and in June alone there were 16 annuity rate cuts.” 6 (Insley, 2012) This means that in the year 2008 a £100,000 pension pot would receive £7,855 income a year, rather than the current £5,743 a year income with the same sized pension pot. With over a 2% decrease in just four-‐years, any further quantitative easing policies would hurt the annuity rates on pension funds. An unplanned side-‐effect of low interest rates and quantitative easing was the rise in global commodity prices as investors sought out higher-‐yielding assets. Speculation in the oil market led to a near doubling of the price of crude between early 2009 and early 2010, with food prices also growing rapidly. The depreciated pound aggravated this as the annual inflation rate rose to above 5% resulting in a reduction in consumer spending power and stalled economic recovery 7 . This shows that quantitative easing in the UK has had effects on the global economy, and as a result prices have been increased significantly even though the value of the pound has decreased. Without quantitative easing, it can be argued that the value of the pound could have fallen greater and that the rise in prices is only a temporary issue until the economy becomes stable again.
These lower levels of interest rates, coupled with an increase in the money supply, made the sterling less attractive to investors. Depreciation of the pound makes UK exports cheaper, providing a boost to manufacturing and parts of the service sector that trade overseas. This shows quantitative easing helps British companies expand globally and stimulate the economy through exports, additionally promoting home produce. Another aim of low interest rates and quantitative easing was to make it less attractive for people to hold cash. This resulted in investors seeking out better yields in property, the stock market, and commodities and an increase in public economics confidence. Lastly, banks benefited from quantitative easing because they were able to exchange various assets like the government gilts for cash, which they used to repair damaged balance sheets as a result of the financial crisis. Without quantitative easing, banks would not have been able to repair their critical
6 http://www.guardian.co.uk/money/2012/jul/05/quantitative-‐easing-‐affect-‐annuities-‐pensions-‐inflation 7 http://www.guardian.co.uk/business/2012/mar/08/low-‐interest-‐rates-‐qe-‐winners-‐losers
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conditions and restore consumer confidence; therefore quantitative easing was a necessary step in ensuring short-‐term financial stability.
How the UK economy applied Quantitative easing As the Bank of England has a high level of independence, it had a pivotal role in the crisis and in applying quantitative easing. In January 2009 amid the continuing financial crises, the Chancellor of the Exchequer authorised the Bank of England to set up the Asset Purchase Facility (APF). The Asset Purchase Facility was created to “buy high-‐quality assets financed by the issue of Treasury bills and the DMO’s cash management operations”8 (Bank of England, December). The aim was to create liquidity in credit markets to encourage spending and furthermore boost economic growth. As highlighted previously, by purchasing open market securities issued by the government in the form of gilts and high quality corporate bonds from the private sector, they would inject the economy with money. Moreover, by purchasing these assets, they drive up the price reducing the yields and encourage money to be invested elsewhere, which would stimulate growth. Figure 6 highlights how much quantitative easing has been undertaken by the Bank of England as of 1st January 2008 until the 1st of November 2012. Figure 1
(Taken from the Bank of England public sector Debt summary tables9)
8 http://www.bankofengland.co.uk/markets/Pages/apf/default.aspx 9http://www.bankofengland.co.uk/boeapps/iadb/index.asp?Travel=NIxSTxTDx&levels=1&C=JS1&FullPage=&FullPageHistory=&Nodes=X42705X42886X42888X42898X42899X42900X45929X45942X47447&SectionRequired=D&HideNums=-‐1&ExtraInfo=false&G0Xtop.x=48&G0Xtop.y=7
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Since January 2008, the bank has increased its spending from £2561million to £371784million. It is also evident that quantitative easing has been done periodically not continuously. Initially the bank of England of England’s goal was to spend £75 billion over 3 months. However the MPC authorised the purchase of £200billion between March and November 2009. This was subsequently followed by a further £75billion in October 2011 and an additional £50billion in both February and July 2012, bringing the total to £375 billion10. This highlights one of the main negative factors of quantitative easing, that it cannot be planned, but rather suffers from implementation lag. However, even after all these injections of funds, policy makers have to contend with impact lag, the delay between the time a policy is introduced until that policy impacts the economy. Not until the 3rd quarter of 2012 have we seen a growth in the economy, showing that quantitative easing has worked but over a longer time than initially expected. The table below shows the outstanding stock of holdings for each facility and identifies how the purchases were funded. This data was captured at the close of Thursday 25 October 2012.11 Stock of holding is on a settled basis, net of any redemption. TYPE OF SECURITY PURCHASED ISSUE OF GILTS & DMO'S CASH
MANAGEMENT OPERATIONS CREATION OF CENTRAL BANK RESERVES
Gilts N/A £371,749,000.00
Corporate Bonds £19,000,000.00 £35,000,000.00
Secured Commercial Paper
£0.00 £0.00
Using the information above, it is evident that the Bank of England is mainly funding quantitative easing through the creation of central bank reserves. The graph below shows the comparison of gilt holdings between the recession and the 1990’s. The gilt holding of banks, building societies and non-‐bank institutions and individuals have decreased whilst, the gilt holdings of the Bank of England have increased significantly. Conclusion To summarise, quantitative easing has both its pros and cons. Quantitative easing is a reaction to a poor economy with sporadic injections of money; it is understandable how the inflation rate took longer to adjust, as it was not a natural increase of money supply. Quantitative easing was only applied in the UK when decreasing interest rates no longer had an effect on AD, in effect creating a liquidity trap. Quantitative easing helped stimulate the British economy by injecting money directly where it was needed, which in this case were the banks in crises. However quantitative easing significantly increased inflation, as well as adversely affected annuities such as pensions because it reduces assets yields. Nonetheless without
10 http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx 11 http://www.bankofengland.co.uk/markets/Pages/apf/default.aspx
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quantitative easing there is no telling how bad the recession could have been. Moreover, there could be more quantitative easing to stimulate the UK’s sluggish growth. Sir Mervyn King has gone on record to say "The immediate economic outlook remains a challenging one. Growth is likely to remain sluggish and inflation above target. The road to recovery will be long and winding."12 (Elliott, Bank of England hints at quantitative easing as growth falters again, 2012) King also expressed there was a limit to the bank’s capability of stimulating the economy unless the international environment improved, though he would not rule out any fresh purchases of government bonds. Therefore quantitative easing can be seen as a temporary solution for stimulating the economy, with long-‐term stability and recovery depends on other factors that help growth.
12 http://www.guardian.co.uk/business/2012/nov/14/bank-‐of-‐england-‐quantitative-‐easing-‐growth
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Bibliography Bank of England. (2010, December). Asset Purchase Facility. Retrieved from
http://www.bankofengland.co.uk/markets/Pages/apf/default.aspx Bank of England. (2011). Quantitative Easing Explained. Retrieved from
http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx
Bank of England. (2012 , November 30 ). Selection Summary. Retrieved from http://www.bankofengland.co.uk/boeapps/iadb/index.asp?Travel=NIxSTxTDx&levels=1&C=JS1&FullPage=&FullPageHistory=&Nodes=X42705X42886X42888X42898X42899X42900X45929X45942X47447&SectionRequired=D&HideNums=-‐1&ExtraInfo=false&G0Xtop.x=48&G0Xtop.y=7
Bank of England. (December, 2010). Asset Purchase Facility. Retrieved from http://www.bankofengland.co.uk/markets/Pages/apf/default.aspx
DineshBakshi. (n.d.). Monetary policy and the economy. Retrieved from DineshBakshi: http://www.dineshbakshi.com/ib-‐economics/macroeconomics/165-‐revision-‐notes/1899-‐monetary-‐policy-‐and-‐the-‐economy
EconomicsHelp.org. (2011). Effects of Rising Interest Rates in UK. Retrieved from EconomicsHelp: http://www.economicshelp.org/macroeconomics/monetary-‐policy/effect-‐raising-‐interest-‐rates.html
Elliott, L. (2012, November 14). Bank of England hints at quantitative easing as growth falters again. Retrieved from The Guardian: http://www.guardian.co.uk/business/2012/nov/14/bank-‐of-‐england-‐quantitative-‐easing-‐growth
Elliott, L. (2012, March 8). Low interest rates and QE: the winners and losers. Retrieved from The Guardian: http://www.guardian.co.uk/business/2012/mar/08/low-‐interest-‐rates-‐qe-‐winners-‐losers
Flanders, S. (2012, July 17 ). UK inflation rate falls to 2.4% in June. Retrieved from BBC News: http://www.bbc.co.uk/news/business-‐18867248
Insley, J. (2012, July 5). Quantitative easing: its effect on annuities, pensions and inflation. Retrieved from The Guardian: http://www.guardian.co.uk/money/2012/jul/05/quantitative-‐easing-‐affect-‐annuities-‐pensions-‐inflation