Purpose and Effectiveness of the Expansionary Policy on Output, Unemployment, Interest rates, and Prices in the Short and Medium Run

Central Banks around the world have been carrying out expansionary policy (quantitative easing) through open market operations since the start of the financial crises.

Explain the purpose of this policy and discuss potential risks associated with it. Describe the impact on output, unemployment, interest rates and prices in the short and medium run. How effective do you expect this policy to be and what factors does its efficacy depend on?

With the emergence of recent financial crisis, economies across the globe have been experiencing quite rough times and faced many difficulties, as well as downturns. Many countries faced the progressively increasing rate of unemployment, big declines in the share of the consumer’s wealth with a subsequent drop of the demand for goods and services. In an urgent necessity of improvement and recovery, governments were designing and implementing various combinations of fiscal and monetary policies, according to the situation on particular markets. Many of the Central Bank’s carried the expansionary policies (or so called quantitative easing) in order to speed up the revitalization of the financial market and speed up the economic growth. The quantitative easing is usually performed via one of the basic and very common monetary tool, - open market operations. In case of the expansionary monetary policy, it means that central banks e.g. Bank of England (UK) or The Federal Reserve (USA) are buying bonds and government securities with the purpose to increase the supply of money in the financial system and the economy. Such purchases of bonds are injecting money into the economy and stimulate its growth. However, as in any other economic tool there are cost and benefits for such policy. In further analysis there will be discussed and outlined the aspects of the purpose of the policy, efficiency dynamics and possible costs and risk of chosen economic policy.

Quantitative easing is often used in order to supply banks with an extra liquidity and increase their capacity to lend money to the firms and businesses, which in return boosts the investment in the economy and as a consequence it shifts the aggregate demand. Because there is more money available to the banks, the cost of borrowing i.e. the interest rate decreases, which also means that investors can take an advantage of newly emerged opportunity of getting the same or greater returns at a lower cost. In other terms, such conditions encourage an increase in investors’ confidence, which is clearly a positive feature. In theory, in the short run such policy should push the economy out of the financial recession by rightward shift of the aggregate output and a fall of the unemployment rate (as partly shown further below on the IS-LM and AS-AD models). On these two graphs the principle logic behind the quantitative easing is shown. In the first case, monetary expansion generates a lower interest rate, which encourages an increase of output due to the rise of the investment. Consequently on the next graph it is illustrated that the increased investment initiates an upward shift of the aggregate demand curve and this explains the rise of aggregate output in the short run.

However in reality monetary policy faces the wide spectrum of influences, which are determined by particular market’s features. Firstly, policy’s efficacy depends on the degree of responsiveness of the investment to changes in interest rate; and secondly the efficiency and result of the policy will be affected by the scale of that decrease of the interest rate caused by money supply expansion. In real economy, firms can follow the domino effect of the “investment depression”, as the unenthusiastic spirit spreads among the investors very quickly and with a confident persuasion. Therefore, in such situations firms are usually not responding to the fall of the interest rate as they are driven by a mass fear of “investment fiasco”; which is exactly what was happening in Europe and United States on the brink of the recent crisis. When the expectations of the future returns are pessimistic and the economy is in an unstable position, firms typically do not make investments, even when they can borrow at the lower interest rates.
Furthermore, especially during the depression conditions the monetary policy can fail to be effective due to the liquidity trap (already observed during the Great Depression (USA), Lost Decade (Japan 90s) and very recent Fed’s actions in 2010). Liquidity trap can be observed when the prevailing short-term nominal interest rates are very low or close to zero, so people tend to assume that the interest rates will rise soon, thus they switch from bonds to savings(because of the inverse correlation with the interest rates) . Therefore, central banks are not capable of “accommodating sufficiently large deflationary shocks by interest rate cuts” (Gauti B. Eggertsson, 2008) and expansionary monetary policy is quite ineffective in such situation.

In the medium run, quantitative easing usually has a risk of resulting in a permanent rise of the price levels and rapidly accelerating rate of inflation in the future, which in turn will have to be adjusted at some point by decreasing the money supply back. Inflation can be a tricky, sometimes hardly controlled outcome of particular policy, as it increases rapidly with the expectations which are naturally based on the previous inflation rate. For this reason economy can fall into trap where the higher inflation expectations will in fact adjust the genuine inflation rate. The impact of the expansionary monetary policy on output and unemployment in medium run depends whether the given economy is operating at the natural level of output or below it, hence the analysis should be committed on a particular case(economy, country) in order to examine these effects.

Reference:

Blanchard, O (2009), 5th Edition. Macroeconomics. London: Prentice Hall.

Gauti B. Eggertsson(2008), Second Edition, Liquidity Trap, The New Palgrave Dictionary of Economics. http://www.newyorkfed.org/research/economists/eggertsson/palgrave.pdf (accessed on 2nd December 2011)

Paul Krugman, 1999, Thinking about the liquidity trap, unknown publisher. http://web.mit.edu/krugman/www/trioshrt.html (accessed on 2nd December, 2011)

Dr. Fidel Perez Sebastian (2011), Lecture slides and notes made during the lectures.
Dr. Ija Trapeznikova (2010), Lecture slides, materials received at seminars and notes made during the lectures.