Money Supply and Quantitative Easing - Assignment Example

Running Header: Bank of England Student’s Name: Instructor’s Name: Institution: Course Code: Date of Submission: QA The debate on the ways in which money should be put into the economy has been raging allover the country. This is because of the economic risk involved in taking such a step. Inflation is the biggest threat from such move. The inflation report on the bank of England reveals view surprising elements. There is a possibility that the bank following the macroeconomic policy can choose to do more purchases of assets as one way of putting more money into circulation.1 According to the report, the Consumer Price Index (CPI) was revised slightly upwards and the inflation is also expected to rise to more than 1.8%. It’s expected that more asset purchase will increase the demand. This is likely to impact on the CPI which has been lifted by the decline in the interest rates. It’s also unlikely that the BoE will promise more of the QE but increase the asset purchase as they lower the lower gilt buying as the other option.2 Change of the buying strategy could play a major role in distorting the gilt markets in order to match the DMO’s issuance. However, this also does not offer the desired strategy as the bank is real worried of the effects of asset purchasing. The other option that is at the bank’s disposal is the printing of more money. However, this could be more risk as this does not take into account the effect on the economic activities. This is because inflation is also likely to hike. Given the current economic crisis in Europe, taking faster measures will provide the fastest and quickest solution in safeguarding the country’s economy. Creation of direct electronic money could over a short term solution that will help keep the economy at easy. This is because the banks’ interest rates will be managed at the required levels as there will be more money in supply.3 However, this has to be traded with caution in order to make sure that inflation does not escalate and hurt the CPI. According to Osborne, the move will stifle economic growth as the government is planning to pump £50bn to the economy in the next few days. Pumping enough money into the economy will help the country increase its GDP which had fallen into recession in the last three years. Even though the move is likely to be criticized by the savers and other pensioners’ groups, it’s believed that if the measure is not taken the country’s inflation rate likely to fall below 2%. In addition, the move is a good measure to strengthening the household real incomes as inflation is controlled as a result of the continued application of the monetary policy.4 Based on the economic conditions and more especially from tight credit terms and the fiscal consolidations, there is a challenge. It’s expected that because of the weak growth, the economy will remain stagnant for sometime. Adjustment of demand and supply of money in an economy is a very difficult thing to implement. It is therefore important to try and make supply and demand balance. In a situation where either the banking sector or the non-bank sector leads in the increase of supply of money, then the factors that determine its supply and demand more especially the nominal spending and wealth as well as rates of return, one sector then must move make sure that households and business companies are willing to reserve more money. At the same time, incase the demand for money rises as it’s the case now by the households or business companies, then something has to be done in order to induce the bank sector to adjust and increase their money supplies to the households and the companies.5 Alternatively the BoE may decide to move a step further to offset the increase in demand for money that originally existed. Most important for BoE is to note is that the determinants that influence supply and demand for money may be not be adjusted immediately but as need arises so as to make sure that factors of the economy are taken into consideration. The standard economic theory, explains that money to be supplied, should be directly related to the demand by households and companies at any particular time.6 Based on this scenario therefore, it is important for the BoE to take due consideration on the amount of money demanded by households and companies so as to balance its demand and supply. This is particularly important in making no excess money that is supplied into the economy which may trigger increase in inflation rates. In this case therefore when purchasing assets by the BoE there is need to take into account the relative importance of the households and the companies. In addition, the asset purchasing is not likely to change the inflation rate and therefore there is also need to continue with buying of gilts in the better part of 2012. The major worry for the BoE should be what to do if there is no impact with after using the QE. This is because the QEs do not have the diminishing returns.7 The graph below shows the Gilt holdings by sector between 2008 and 2010. In order to make the QE more effective and at the same time encourage banks to continue lending rather than holding their reserves at the BoE, there is need for the BoE, through the Monetary Policy Committee to cut into zero the reserve rate. This will automatically discourage the banks from holding a lot of reserve in the BoE. This will go along way in forcing the banks to supply more money to the households and the companies and therefore influencing positive change in the supply of money. Diagram 1: Gilt holdings by sector between 2008 and 2011 Q2 The decision by the BoE to apply the asset purchase strategy to increase the supply of money in the market has got several effects. It’s likely that the move will have an immediate and unavoidable effect on those bonds that are held by that have not reached their maturity. The bond yields are likely to decline following the recent announcement by the BoE to purchase assets. This problem is likely to persist for the next five to ten years. The effect is even expected to be even worse in the view months. In addition, the move by the BoE is likely to have some impact on the corporate bond yields. The effect is likely to be that the corporate bonds are likely to reduce their yields.8 Its is likely that the announcement by the BoE that it will embark on purchasing assets will translate into the decline of the UK BBB bond yields by almost 56 basis points in just one day and 98 in just two days. This is a scenario that will be demonstrated by investors trying to readjust their portfolios given the bank’s move. Further, the there is a likelihood that there will be significant depreciation on the side of the nominal exchange rates. Another effect that is related with the move by the bank is the stabilizing effect on the financial markets. The volatility in the stock prices which act as a proxy for the overall uncertainties in the financial markets is likely to fall. Finally, the push by the BoE to embark on asset purchases is likely to push the prices of those assets that have been bought and all other assets upwards.9 This is because once the bank decides to purchase these assets, then it means that the money invested on the holders is likely to increase. Unless money is used by the bank as the perfect substitute for those assets that are sold, the sellers are likely to look for other options that are likely to balance their portfolios.10 This is likely to be replicated by a scenario where the sellers of the assets will have excess money which they will spend readjusting their portfolios by buying more assets. This process is likely to trigger asset price increases until the investors reach a point where they are ready to hold certain amount of money and assets. When the asset price is higher, then it will mean that it means lower yields and less borrowing costs by households and firms and people will be more willing to spend given the liquidity base. In general, asset purchasing programmes as used by the bank have a significant influence in reducing the yields that are generated from long-term bonds. The government bond yields are also likely to be affected while the prices of those assets that are perceived to be high risk are expected to increase. It’s expected that the purchasing of assets will have a long-term and serious impact as will be demonstrated in the withdrawing of bonds from the market supply. References 1. Benford, Berry K et al, Quantitative easing, (Bank of England Quarterly Bulletin 2009), vol 49, no 2, pp 90–100. 2. Chen, Filardo D et al, The impact of central bank balance sheet policies on the emerging economies, (manuscript, Bank for International Settlements and Hong Kong Institute of Monetary Research, 2011). 3. Cross, Fisher P et al, The Bank’s balance sheet during the crisis, (Bank of England Quarterly Bulletin, 2010), vol 50, no 1, pp 34–42. 4. D’Amico, King T., Flow and stock effects of large-scale treasury purchases, (Federal Reserve Board Finance and Economics Discussion Series, 2010), 2010–52. 5. Gagnon, Raskin M et al, The financial market effects of the Federal Reserve’s large-scale asset purchases, (International Journal of Central Banking, 2011), vol 7, no 1, pp 3–43. 6. Hamilton, Wu C, The effectiveness of alternative monetary policy tools in a zero lower bound environment, (NBER Working Papers, no 16956, 2011) 7. Joyce, Lasaosa M et al, The financial market impact of quantitative easing, (Bank of England Working Papers, no 393. 2010) 8. Krishnamurthy, Vissing-Jorgensen A,: The effects of quantitative easing on interest rates: channels and implications for policy, NBER Working Papers, no 17555, 2011). 9. Swanson, E, Let’s Twist again: a high-frequency event-study analysis of Operation Twist and its implications for QE2, (Brookings Papers on Economic Activity, spring, 2011), pp 151–88. 10. Williams, J, Unconventional monetary policy: lessons from the past three years, (Federal Reserve Bank of San Francisco Economic Letter, 2011). Read More