Quantitative Easing refers to central bank purchases of assets other than short-term maturity government debt. To what extent does QE differ from conventional monetary policy, and how may its efficacy change once short-term interest rates are close to or at zero? -Richard Jones, Year 12

The central bank controls the banking system and implements monetary policy on behalf of the government, the central bank in the UK is the Bank of England. As stated in the essay question, QE refers to the purchase of assets such as long dated government bonds -gilts- and some corporate bonds mainly from financial institutions such as insurance companies and pension funds, which is financed by new money that the Bank of England creates electronically. The central bank does not purchase short-term maturity government debt due to the insignificant time gap between the issue date and the maturity date. Conventional monetary policy involves the Bank of England raising or lowering bank rate to manage the level of aggregate demand, thus controlling the rate of inflation and hitting the CPI target of 2%, whilst also supporting the government’s economic policy objectives, including those for economic growth and unemployment. Short-term interest rates are the rates at which short-term borrowings are distributed between financial institutions.
Both quantitative easing and conventional monetary policy influence aggregate demand by affecting the money supply in the economy. However, there are significant differences between the two. As aforementioned, conventional monetary policy uses bank rate to manipulate aggregate demand in the economy. If the government wants to increase real national income, employment and CPI inflation, then an expansionary monetary policy -lower bank rate- would implement this. A lower bank rate would reduce the rate of interest that the Bank of England pays on reserve balances held by commercial banks and building societies, which should in turn lower the LIBOR -the rate of interest at which banks lend to each other-; a lower LIBOR leads to a lower interest rate that commercial banks charge their customers.
A reduction in interest rates makes saving less attractive and borrowing cheaper, incentivising borrowing thus consumption. In addition to lower interest rates decreasing the costs of servicing mortgage or credit card debt which increases the level of household disposable income. It may also cause asset prices to rise which increases personal wealth; both factors increase consumption which causes aggregate demand to increase. Not only does consumer confidence increase thus, but business confidence increases as lower interest rates will incentivise investment due to the cost of borrowing to buy capital goods being lower.
Lower UK interest rates lead to increased selling of the pound sterling on foreign exchange markets, as owners of international capital decide to hold other currencies instead. This causes the pound’s exchange rate to fall, which increases the price competitiveness of UK exports in world markets. At the same time, the prices of imports rise and they become less competitive in the UK market causing imported inflation to ensue. The UK’s balance of payments on current account improves, with the increase in net export demand shifting the AD curve to the right.
Changes in spending channel through into real output and in turn, into employment. That can affect wage costs for labour by changing the relative balance of supply and demand for workers. But it also influences wage bargainers’ expectations of inflation which is a key consideration for the eventual wage settlement. The impact on output and wages channels through to producers’ costs and prices, and eventually consumer prices. A decrease in interest rates causes aggregate demand to increase, and assuming there isn’t deficient demand in the economy consumer price inflation increases also. The opposite is true for an increase in interest rates, which causes consumer price inflation to decrease.
There are time-lags before changes in interest rates affect spending and saving decisions, the maximum impact of a change in interest rates on real output is estimated to take up to one year, and the maximum impact on consumer price inflation takes up to two years, so interest rates must be set based on judgements on the economic outlook over the coming few years, not what it is today.
Let the condition of goods market (flow) equilibrium be (Y = C(Y-T(Y)) + I(i) + G + NX) where C(Y-T(Y)) = consumer spending as a function of disposable income, I(i) = Investment as a decreasing function of interest rate, G = Government spending and NX = Net exports.
This equation can be presented as a negative relationship between income and the real interest rate. The downward sloping flow-equilibrium curve which I have drawn as a straight line only for simplicity is called the IS curve. IS comes from the fact that in a closed economy -one with no international trade- the curve gives the combinations of income and the interest rate for which effective investment equals effective saving. In an open economy, this curve gives the combinations of income and the interest rate for which the desired net capital outflow, represented by savings minus investment, equals the desired current account balance.
The diagram below evidently shows that a fall in the interest rate leads to an expansion of investment, causing equilibrium output, income and employment to increase as we extend along the IS curve. A fall in the real exchange rate shifts world demand for domestic goods to the right, increasing income at each level of the real interest rate and shifting IS to the right. An increase in rest-of-world income, or an exogenous increase in consumption or investment or net exports at any given level of the real interest rate also causes the IS curve to shift to the right and the equilibrium level of output, income and employment to increase.

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Alternatively, the Bank of England purchases assets in response to a sharp fall in aggregate demand as consumers and firms reduce their spending; the aim is to boost spending to keep inflation on track to meet the CPI inflation target. As aforementioned in the opening statement the Central Bank purchases assets from private sector firms including insurance companies and pension funds, high street banks and non-financial firms, but mostly gilt-edged securities; the UK’s central bank was also considering purchasing university debt, like the £350 million bond issued by Cambridge University in December 2016. ‘’The Bank of England’s injection of money into the economy works through different channels and has a variety of potential effects’’ as cited from the Bank of England’s website.

When the bank buys assets this increases their price and so reduces their yield, meaning the return on those assets falls. This encourages the sellers of assets to use the money they receive from the bank to switch into other financial assets like company shares and bonds -Portfolio balance effects-. When financial markets are dysfunctional, central bank asset purchases can improve market functioning by increasing market liquidity through actively encouraging trading. Asset prices may subsequently increase as a result of decreased illiquidity premia -liquidity effects-.

As purchases of these assets start to increase, their prices rise which pushes down on yields generally. This also leads to policy signalling effects.

 

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Lower yields decrease the cost of borrowing for businesses and households, which leads to higher consumer spending and more investment. Higher asset prices make some consumers better off, which provides an extra boost for spending on goods and services.

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The graph above illustrates what happens in the economy when the Bank of England buys assets from financial institutions: the money supply increases in the economy which leads to falling interest rates, thus reducing the opportunity cost when planning investments due to attractive loans, and subsequently output increases. Put in technical terms, money supply shifts rightward from MS to MS1 which causes an extension of money demand -MD-. The result is lower interest rates and an increase in real money.

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The effect of quantitative easing can be seen using another IS-LM model above. QE causes the LM curve to shift to the right. This shift extends along the IS curve; the new lower equilibrium rate induces investment and hence, higher output. This is the penultimate objective of QE , to increase the money supply, hence ceteris paribus, decreasing interest rates resulting in increased UK output, lower unemployment and finally, higher CPI.

The efficacy of QE may decrease the closer short term interest rates get to zero. This is a result of a number of factors including panic signals, mass debt payoffs, and liquidity traps.

Panic signals are psychological motivators in the economy which heed caution and precautionary saving when consumers believe the economy is not behaving in the way it should. As you can see in the graph below, the red line showing UK short term interest rates is at an all time low. As UK citizens are used to these interest rates being around 6% -mean- during the period in this graph, they may feel that the economy is in a dire situation for short term interest rates to fall to 0.57% in Q4 of 2015, thus reducing consumption.

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The black line in the graph above shows short term interest rates in the Eurozone, which are at an even lower rate than the UK, suggesting that these panic signals may be foreign as well as domestic. This may lead to decreasing export demand for the UK, thus reducing the price level.

Although Central Bank asset purchases can improve market functioning by increasing market liquidity through actively encouraging trading, panic signals may reduce the velocity of money in Fisher’s Equation of Exchange; perhaps at a greater rate than the rate of increase in the stock of money, thus having a negligible effect on the price level and the quantity of real output in the economy.

In addition to this, due to short-term interest rates being at or close to zero, consumers may try to pay off their debts and mortgages sooner because it is cheaper to do so. If the mortgage companies’ and banks marginal propensity to consume is less than that of other firms, this may reduce consumption in the economy from what it was when short term interest rates were a couple of percentage points higher, decreasing AD and the price level. The graph below proves that it is becoming cheaper to pay off mortgage debt.

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A liquidity trap occurs when low or zero interest rates fail to stimulate consumer spending, and monetary policy becomes ineffective as consumers prefer liquid assets greater than the rate at which the quantity of money is growing, so any attempt by policy makers to get individuals to hold non-liquid assets in the form of consumption by increasing the money supply won’t work; Quantitative Easing becomes ineffective as a policy. In general the closer the equilibrium is to the Keynesian range – which is the horizontal segment of the Keynesian aggregate supply curve that reflects rigid prices and wages –  the less effective monetary policy becomes.

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To reiterate, in the liquidity trap region, monetary policy is completely ineffective in stimulating income. Despite an increase in money supply, the LM curve does not shift. An increase in the money supply cannot cause the interest rate to fall below the rate given by the liquidity trap. Equilibrium income then remains at OY0.

However there are many common criticisms with the liquidity trap, the first being that even if possible in theory, conditions required are so extreme as to be unlikely to arise in practice. In addition to this, a wealth effect of real money balances implies that increases in M/P must stimulate aggregate demand even if there is no effect on interest rates -Pigou effect-. Finally, even if short-term interest rates cannot be further reduced, monetary expansion will affect aggregate demand by raising other asset prices, especially if the Bank of England purchases longer-term or risky assets.

Japan has experienced deflation and record low interest rates for decades. It is caught in a liquidity trap. The Bank of Japan’s argument is that they’ve got interest rates down to zero and they question what else they can do. According to Milton Friedman it’s very simple. ‘’They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high-powered money starts getting the economy in an expansion’’. Milton Friedman was clearly dovish during this period.  The quote almost perfectly mirrors the situation the United States has found itself in since 2008-2013. Zero interest rates have fooled a lot of people into thinking monetary policy is loose, but in reality it’s been tight, as indicated by the below-target inflation rate.

To conclude, I believe it to be necessary to briefly outline the differences between open market operations in the U.S and quantitative easing, to discover whether there are any similarities between UK and US monetary policy.

The Fed has 3 main instruments to influence monetary policy, these are open market operations, discount rate and reserve requirements. Discount rate is near equal to bank rate, market operations is the Fed constantly buying and selling U.S government securities in the financial markets, this impacts the level of reserves in the banking system. These decisions by the Fed also affect the volume and the price of credit -interest rates-. Reserve requirements are the amount of physical funds that depository institutions are required by law to hold in reserve against deposits in bank accounts. It determines how much money banks can supply through investments and loans.

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Conventional open market operations are meant to influence the left end of the yield curve. The aim is that by directly moving the left end up or down, the whole curve will go up or down indirectly. The Fed does this by buying and selling short-term bonds.

 

Quantitative Easing is trying to directly affect the other parts of the yield curve by buying and selling bonds with those maturities. The hope of indirect influence on that part of the yield curve hasn’t been effective, so policy makers are trying to do something about it directly.
Another thing that’s different is what is exchanged for the bonds; in Conventional open market operations it’s reserves, whilst with quantitative easing it’s money. Either way the idea is to get the banks to lend more than they otherwise would -assuming the central bank is trying to expand the economy-. The last thing that’s different is the intermediate target used. With open market operations the FED is looking at interest rates first, however with quantitative easing policy makers are  looking at influencing the amount of money in circulation.

Bibliography

 

  • Benford, J, Berry, S, Nikolov, Young, C  ‘Quantitative easing’  Vol. 49, No. 2. (2009)

 

  • Joyce, M and Meldrum, A, ‘Market expectations of future Bank Rate’, Bank of England Quarterly Bulletin, Vol. 48, No. 3 (2008)

 

  • Levy Economics Institute of Bard College (Working Paper No 862) (2016)

 

  • Bank of England website

 

  • Confronting Monetary Policy Dilemmas: The Legacy of Homer Jones (Beryl W. Sprinkel)  (2013)

 

  • Robust Monetary Policy under Model Uncertainty (Alexei Onatski) (2000)

 

  • The Relation Between Quantitative Easing and Bubbles in Stock Markets (Thomas Hudepohl) (2016)

 

 

 

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