Is Quantitative Easing a Suitable Policy? … Research Paper
Pages: 7 (2223 words) | Style: n/a | Sources: 7
¶ … Easing:
Its use in the U.S. And its impact upon the world economy
Quantitative easing is the process by which central banks manage the money supply. For example, the U.S. Federal Reserve recently began to cut back on its monthly purchases of government and mortgage bonds, tapering the policy of monetary expansion it pursued in the wake of the 2008 recession. "Central banks are responsible for keeping inflation in check. Before the financial crisis of 2008-09 they managed that by adjusting the interest rate at which banks borrow overnight," also known as the discount rate ("The Economist explains"). "If firms were growing nervous about the future and scaling back on investment, the central bank would reduce the overnight rate. That would reduce banks' funding costs and encourage them to make more loans, keeping the economy from falling into recession. By contrast, if credit and spending were getting out of hand and inflation was rising then the central bank would raise the interest rate" thus discouraging borrowing and lending ("The Economist explains"). However, even when rates were zero, banks were still not borrowing in 2008, which spawned the Fed's policy of purchasing government and mortgage bonds, or quantitative easing, to accelerate the economic recovery. The policy continued for many years given recent concerns about the shakiness of that recovery: there are still high unemployment rates in many areas of the country. The Fed only officially discontinued the quantitative easing policy this year and even then certain facets of the policy remain. This paper will provide a rationale for the policy as well as a brief overview of its future.
How quantitative easing works
Purchasing securities has traditionally been one of the ways the Fed infuses money back into the economy as money is no longer 'tied up' in savings instruments such as bonds. Quantitative easing, however, makes use of 'new' money. "To carry out QE central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before. The new money swells the size of bank reserves in the economy by the quantity of assets purchased -- hence 'quantitative' easing" ("The Economist explains"). Knowing when to use quantitative easing, however, is anything but easy and the policy is controversial. "Studies suggest that it did raise economic activity a bit [in 2008]. But some worry that the flood of cash has encouraged reckless financial behaviour and directed a firehose of money to emerging economies that cannot manage the cash. Others fear that when central banks sell the assets they have accumulated, interest rates will soar, choking off the recovery" ("The Economist explains"). Quantitative easing, in its manner of apportioning assets, places a greater emphasis on private sector bonds than the Fed traditionally does when buying securities to expand the money supply. The Fed usually emphasizes the buying-up of government-generated bonds. But in 2008, there was a greater emphasis on private sector assets because of the specific origins of the crisis.
The 2008 recession
Over the course of the 2008 recession and credit crisis and the Fed's subsequent expansionist monetary policy response, its emphasis was on buying up private sector bonds. "When the bank seeks to promote economic growth, it buys government bonds, which lowers short-term interest rates and increases the money supply. This strategy loses effectiveness when interest rates approach zero, forcing banks to try other strategies in order to stimulate the economy. QE targets commercial bank and private sector assets instead, and attempts to spur economic growth by encouraging banks to lend money" ("Quantitative easing," Investopedia). This policy is more aggressive in its expansionist impulse and stands a greater change of stimulating the economy although there is also a subsequent risk of stimulating inflation as well.
The severity of the 2008 recession was one of the reasons for the buying-up of private securities: also, the specific nature of the financial collapse, which began in the housing sector. The Troubled Asset Relief program did not simply free up money and increase its circulation in the economy like traditional expansionist programs: it was specifically designed to rehabilitate the financial industry which had been gutted thanks to the bottoming-out of the subprime housing market. "TARP was intended to increase the liquidity of the secondary mortgage markets by purchasing the illiquid MBS, and through that, reducing the potential losses of the institutions that owned them" ("TARP," Investopedia). Ultimately, Congress authorized over $475 billion through the TARP program to bolster the financial sector by buying back toxic assets ("TARP," Investopedia). Quantitative easing channeled potential investment dollars into the spheres of the economy where the Fed believed growth was needed, not necessarily into the most appealing or safest assets. "When the Fed took trillions in government bonds and mortgage securities off the market, the investors who would have bought them had to find something else to buy. Often the answer was corporate bonds. With the increased demand, prices of those bonds went up and the interest rate that large companies must pay to borrow money on the bond market fell. That made the environment more favorable for companies looking to expand or refinance old debts" (Irwin 1).
However, the concept of quantitative easing did not operate entirely as predicted. It was assumed that "if the money multiplier and velocity were constants, then the monetary base would be high-powered indeed. Any increase in the base (which the Fed can manipulate at will) would cause a proportional increase in nominal GDP. The only thing left to determine would be how much of the change in nominal GDP would express itself as an increase in real output and how much as inflation" (Dolan). But inflation did not increase substantially, contrary to economist's predictions, nor did initial output increase as expected and generate predicted job growth. Moreover, federal policy (because of an unwillingness to engage in massive amounts of deficit spending, given the size of the current deficit) also remained extremely sluggish, generating a relatively stilted economic recovery rate. "The monetary base soars as the Fed buys up vast quantities of financial assets, but the money stock barely budges. The divergence of those two series indicates a precipitous decrease in the money multiplier. Meanwhile, nominal GDP continues to fall for a year or so, and even after that, it grows more slowly than the money stock. The divergence of the money stock and nominal GDP indicates a decrease in velocity" (Dolan). Employment also rebounded far more slowly than predicted.
The future of quantitative easing
"QE's detractors point out that central banks around the rich world have expanded their balance-sheets by trillions of dollars in recent years (see chart), yet are still nurturing lacklustre recoveries. Nonetheless, there is a consensus among researchers that QE has indeed lowered borrowing costs, and thus increased both economic output and inflation, as its advocates intended. In both America and Britain, for instance, several studies have concluded that it helped to lower interest rates. Those declines are generally held to have boosted economic growth" ("Early retirement," The Economist). It should also be noted that the 'death' of quantitative easing has been somewhat prematurely predicted. Although the Fed has formally ended the program, its effects are still being felt because the Fed has made fundamental changes in its approach to ownership of such assets, causing some economists to call the policy "gift that keeps on giving" (Coy). Although it is no longer in an aggressive buy-back campaign, "the Fed will still own all those bonds it bought, and according to the agency itself, it's the level of its holdings that affects the bond market, not the rate of addition to those holdings. Having reduced the supply of bonds available on the market, the Fed has raised their price. Yields (i.e. market interest rates) go down when prices go up. So the effect of quantitative easing is to lower interest rates for things Americans actually care about, such as 30-year fixed-rate mortgages" (Coy). This has been critical in revitalizing the American housing sector: although it has not regained the health it possessed before the housing bubble burst, home values have begun to regain more normative levels consistent with the actual values of the homes. Such retrenchment has proven to be a critical component of economic success, given the extent to which American's homes are tied up in the value of their houses.
Opponents of the TARP criticized it for its flagrant defiance of the concept of 'moral hazard' or the notion that economic actors should have to shoulder the consequences of negative actions as a deterrent to pursuing risky behaviors in the future. There are also still fears that over the long-term, quantitative easing could result in increasing inflation rates, even though no such a spike was seen in the short-term. However, unemployment rates as a whole are going down. There is no longer the dangers of deflation feared during the worst of the 2008 recession (which could have been catastrophic to industry); nor have the fears… [END OF PREVIEW]
Cite This Paper:
APA FormatIs Quantitative Easing A Suitable Policy?. (2014, December 30). Retrieved April 25, 2017, from http://www.essaytown.com/subjects/paper/quantitative-easing-suitable-policy/5856315
MLA Format"Is Quantitative Easing A Suitable Policy?." 30 December 2014. Web. 25 April 2017. <http://www.essaytown.com/subjects/paper/quantitative-easing-suitable-policy/5856315>.
Chicago Format"Is Quantitative Easing A Suitable Policy?." Essaytown.com. December 30, 2014. Accessed April 25, 2017.