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- Reasons for Applying Quantitative Easing
Quantitative easing is an alternative form of monetary policy in which the central bank purchases government securities in order to stimulate money supply and lower interest rates. The technique of quantitative easing aims at flooding financial institutions with capital in order to promote increased liquidity and lending, which in turn increase money supply. By targeting increased private sector spending in the economy, quantitative easing aims to return inflation to manageable levels. Generally, quantitative easing is considered when short term bank interest rates are at or approaching zero. The process does not involve printing of new currency notes as this could be detrimental to the economy (Joyce & Tong, 2012).
There are factors that could have motivated the ECB president to apply quantitative easing within the Eurozone. One of these factors could have been the need to boost economic growth in the Eurozone by encouraging more lending by European commercial banks. It is the case that before the decision to apply quantitative easing, interest rates in the European Union were substantially low, and in some cases approaching zero. The low rates were a disincentive to commercial banks as they risked lending money to the private sector. The decision by the ECB to apply quantitative easing could raise interest rates and encourage commercial banks to increase their lending levels. This could in turn encourage more private sector entities to seek finances to invest in the economy (Krishnamurthy & Vissing-Jorgensen, 2011).
Another motive could have been the desire to maintain health price levels in the Eurozone. A low and stable inflation is crucial to a prosperous and thriving economy in the eurozone. By applying quantitative easing, the ECB aims to keep inflation at target levels to spur more economic activity in the Eurozone. To achieve this, the ECB could ease long term interest rates by attempting to increase money supply by buying securities from holders. By reducing interest rates, the ECB encouraged financial institutions avail more loans to private borrowers. This has the effect of keeping inflation at low levels, which is vital for meaningful economic growth (Peersman, 2011).
The third reason could be encourage investors to seek refuge in riskier investments because of higher returns. Quantitative easing programs have the effect of substantially forcing down interest rates, especially yields on interest rates. This generates investment increases in company bonds, stocks and such like riskier but high return investments. In essence, quantitative easing generates wealth for individual and corporate investors (Kiyotaki & Moore, 2012).
- Advantages and Disadvantages of Quantitative Easing
Quantitative easing can be both a beneficial and a risky move. On the positive side, quantitative easing encourages more lending by financial institutions. In providing commercial banks with more cash, the central bank compels these institutions to be more willing to lend out more money to the private sector. Such loans in return act to further boost the economy through high business development and consumer spending. As more money enters the economy, the general public and consumers have more money to spend. This in turn increases business profits and creates more jobs. Ultimately, this cycle could result in new levels of consumer confidence and economic recovery especially during periods of economic stagnation (Christensen & Rudebusch, 2012).
Another advantage of Quantitative Easing is that compared to other monetary measures, it does not involve currency manipulation. Although Quantitative Easing increases money supply, it does not involve printing of actual money or devaluation of currency. This keeps the current account very competitive, while promoting economic recovery and higher employment. Moreover, quantitative easing reduces the need for austerity measures in cutting budget deficits. Austerity measures are not advisable considering the size of the Eurozone’s economy and the unique challenges associated with each country’s economy (Baumeister & Benati, 2010).
The main disadvantage of Quantitative Easing is that it can drive inflation much higher and hurt the economy. This is the biggest concern for central banks and governments in general. As more money circulates freely through the economy, prices are likely to rise. As supply of money increases, the supply of goods remains the same, thereby increasing the competition for goods. This leads to increased prices, causing inflation to soar. Excessive inflation can cause the economy to operate inefficiently. Another disadvantage of Quantitative Easing is that it creates tension with international trade partners. Increased money injected into the economy can be used by consumers and the government to import new services and goods from other countries. In the long run, this may cause the value of the importer’s currency to decrease and thus discourage more international trade. For example, China stopped exporting minerals to the United States due to the latter’s quantitative easing program (Joyce & Tong, 2012).
Another potential disadvantage of Quantitative Easing is that it encourages uncontrolled debts. Increased money supply and low interest rates encourages additional borrowing by both businesses and consumers. Although some debt can help stimulate economic growth, excessive debts as a result of wanton loans can further exacerbate an already fragile economic situation. Moreover, Quantitative Easing can cause increase government deficit as was witnessed in the United States in 2010 where it reached debt ceiling (Eggertsson & Woodford, 2003). A study by Bridges and Thomas (2012) revealed that most benefits associated with Quantitative Easing do not outlast the QE programs. When the central bank stops supplying more money, economic recovery often gets put on hold or begins to reverse. Although there is hope that new consumer confidence will inspire fast economic recovery, this only tends to be a short-term economic fix. This effect is evidenced by the fact that whenever Quantitative Easing programs are about to end, stock markets tend to fall.
Critics of quantitative easing in the eurozone argue that the program is a stealth method of reducing the value of the Euro and therefore making eurozone exports cheaper. This can be unfair for emerging markets within the eurozone as they see their exports become less competitive internationally (Joyce & Tong, 2012). Because eurozone debt is financed by Quantitative Easing, individual governments in the eurozone may be tempted to enforce less market discipline with regard to reduction of fiscal deficits and tackling of underlying economic problems. If this is sustained long enough, public sector debt may rise uncontrollably. The end result would be unexpected rise in commodity prices, leading to cost-push inflation. According to Christensen and Rudebusch (2012), large scale quantitative easing could make it extremely difficult to sell bonds back to the market once the QE program is ended. This can potentially damage the ability of the consumers and private sector to borrow in future, thereby leading to higher interest rates and reduced economic growth.
- Nash Equilibria
The Nash equilibrium are when the two policy makers agree on the mixture of policies, that is both follow a contractionary policy or an expansionary policy. In either case, the pay off is higher as shown in the payoff matrix. If both policymakers pursue a contractionary policy, the payoff is (3, 2). For this choice of action, 3 is the maximum of the second row while 2 is the maximum of the second column. Hence, both policy makers pursuing a contractinary policy results in Nash equilibrium. If both policymakers pursue an expansionary policy, the reward is (2, 3). 2 is maximum in the third row while 3 is maximum in the third column. Hence taking the expansionary policy also results in nash equilibrium. This shows that agreeing on mixture of policies is the best decision both policymakers would make. Disagreeing would result in nil payoffs for either policy makers, hence none would like to take such a move.
- Best Choice Analysis: Choosing Between Contractionary And Expansionary Policies
Contractionary and expansionary policies are two types of policies commonly used to correct economic inefficiencies. The contractionary policy is used as a macroeconomic tool by the central bank to slow down an economy. Generally, contractionary policies are enacted to limit money supply and ultimately the amount of spending in a country. This is achieved by raising interest rates, reducing the money supply and by increasing reserve requirements. Contractionary policies are used mostly during periods of high economic growth rate, during which time, spending and availability of money are high (Wright, 2012).
Contractionary policies work by increasing the interest rates at which central banks lend commercial banks. This has the effect of increasing the rate at which commercial banks lend individual and private sector investors. When commercial banks’ lending rates are higher, it becomes expensive for investors and individuals to get loans. This reduces spending and eventually contains inflation. Contractionary policies also work by requiring commercial banks to keep cash reserves to enable them meet withdrawal demands. Increasing reserve requirements reduces the amount of money available for banks to lend. As a result, there is lower money supply in the economy (Woodford, 2003).
The main advantage of contractionary policy is that is reduces inflation by stabilizing prices and increasing consumer confidence. This leads to non-erratic consumption due to reduced price fluctuations. Because it involves less government expenditure, government revenue can be used to pay of debts. The main drawback of contractionary policy is the reduction of economic growth as s result of the reduction in supply of money. This can lead to stunted economic growth if the contractionary policies are prolonged (Wright, 2012).
Expansionary policy on the other hand is a form of fiscal policies aimed at increasing money supply in an economy. Inflationary policies are generally adopted during periods of low economic growth and have an effect of increasing government expenditure. Expansionary policies can be implemented in the form of tax cuts, increased government spending or rebates. Generally expansionary policies increase the demand for foreign bonds. It also leads to increased exports, which helps maintain balance of trade (Joyce & Tong, 2012).
Expansionary policies are a useful tool for managing periods of low economic growth. It fuels economic growth of the country by reducing restrictions on loans and interest rates, leading to increased outpour of capital into the economy. Due to an increase in revenue and profits, expansionary policies result in increased demand for labor. Easier borrowing acts as an incentive for firms to increase operations and hire new employees. Thus, expansionary policies lead to reduction of unemployment (Bridges & Thomas, 2012).
On the flip side, expansionary policies are associated with many risks which make the policies less applicable. First, it is difficult for policymakers to precisely know when to expand money supply so as to avoid causing high inflation. There is also a wide time lag between the time when the policy is put in place and when it produces the desired effects in the economy (trickle down effect). Another risk is that expansionary policies increase the level of government expenditure, thereby leading to reduced national revenue. A severe reduction in government taxes would lead to an increase in government budget deficit (Woodford, 2003).
In conclusion, both contractionary and expansionary policies are crucial in managing the economy. As highlighted in the foregoing discussion, both policies have their benefits and risks, and are applied under different economic circumstances. Regarding the case of the two policy makers (Finance Minister and Central Banker), they must take into account the prevailing economic scenario before agreeing on the right policy. The factors influencing money supply must be analyzed in details so that the most optimal decision can be implemented. Since the two policies cannot be pursued simultaneously, it is prudent for the two policymakers to understand the pros and cons of each policy vis-à-vis the economic situation to avoid loss of capital.
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