Quantitative Easing Overview
EC2202
Autumn Assignment – Quantitative Easing
The failure and futility of a 0.25% interest rate combined with low aggregate demand, greater market uncertainty and a sluggish recovery from a US economy coming out of the deepest recession since the 1930’s, has directed the US Federal Reserve to introduce quantitative easing.
The measure involves increasing the US Federal Reserve’s credit balance in order to buy assets (treasury securities i.e. debt) which lowers the supply, increases their price and lowers the yield, consequently lowering interest rates across various sectors of the economy. In an ideal world, lower interest rates would boost the US mortgage market as refinancing will become easier, and through the increase in bank deposits, banks would have a better funding position and thus a greater willingness to lend to new businesses. An open economy like the US’s may see a rise in exports too if demand is pushed towards the stock and corporate bond markets as the Federal Reserve buys up more treasuries, which would in turn depreciate the currency. As a knock-on effect, a weaker currency would imply higher commodity prices in industries such as oil and gold, that is a supply side shock which would raise expected levels of inflation.
In summary, quantitative easing raises asset prices, depreciates the currency and induces expected inflation, and as a result leads to lower interest rates which revive aggregate demand and boosts the economy into higher levels of output. However, if expected inflation offsets the effect of an increase in nominal money (a decrease in the interest rate), output may not increase at all.
The risks of such a policy will be appropriately mentioned later but first, below are the AD-AS and IS-LM diagrams which demonstrate the policy in effect.
Interest LM Rate LMSR
LM2
I1 A C ISR B IS
YN YSR Output AS1
Price AS Level
Autumn Assignment – Quantitative Easing
The failure and futility of a 0.25% interest rate combined with low aggregate demand, greater market uncertainty and a sluggish recovery from a US economy coming out of the deepest recession since the 1930’s, has directed the US Federal Reserve to introduce quantitative easing.
The measure involves increasing the US Federal Reserve’s credit balance in order to buy assets (treasury securities i.e. debt) which lowers the supply, increases their price and lowers the yield, consequently lowering interest rates across various sectors of the economy. In an ideal world, lower interest rates would boost the US mortgage market as refinancing will become easier, and through the increase in bank deposits, banks would have a better funding position and thus a greater willingness to lend to new businesses. An open economy like the US’s may see a rise in exports too if demand is pushed towards the stock and corporate bond markets as the Federal Reserve buys up more treasuries, which would in turn depreciate the currency. As a knock-on effect, a weaker currency would imply higher commodity prices in industries such as oil and gold, that is a supply side shock which would raise expected levels of inflation.
In summary, quantitative easing raises asset prices, depreciates the currency and induces expected inflation, and as a result leads to lower interest rates which revive aggregate demand and boosts the economy into higher levels of output. However, if expected inflation offsets the effect of an increase in nominal money (a decrease in the interest rate), output may not increase at all.
The risks of such a policy will be appropriately mentioned later but first, below are the AD-AS and IS-LM diagrams which demonstrate the policy in effect.
Interest LM Rate LMSR
LM2
I1 A C ISR B IS
YN YSR Output AS1
Price AS Level
References: * Financial Times Interactive graphics. http://www.ft.com/cms/s/8ada2ad4-f3b9-11dd-9c4b-0000779fd2ac,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F8ada2ad4-f3b9-11dd-9c4b-0000779fd2ac.html&_i_referer=#axzz17L8dGelw * Sudeep Reddy, Wall Street Journal. http://online.wsj.com/article/SB10001424052748704506404575592722702012904.html * Vincent Reinhart, Wall Street Journal http://online.barrons.com/article/SB50001424052970204742304575546140224527342.html#articleTabs_panel_article%3D1 * Blanchard, O., “Macroeconomics”, 3rd edition, Prentice Hall (Chapter 7)