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Saturday, 5 October 2013

Quantitative easing? What's that?

by Viva Avasthi



quantitative easing
This diagram shows the first part of the quantitative easing process.
Credit to awadvisors.com


You've probably heard of 'quantitative easing' when listening to the news, or read a bit about it and its implications while perusing various newspapers. It may have sparked your interest, but you might have found that in trying to do a little research on the topic you ended up having masses of technicalities to understand and opinions to wade through. If that's the case, you'll hopefully find this series useful.

The most recent reportage on quantitative easing (also known as QE) involved the US Federal Reserve's announcement in June of this year that it would scale back on its QE, and then its unexpected decision last month to postpone the scaling back. Both announcements (in June and in September) drastically affected markets and the economies of countries outside of the US, most notably India and China. The impact of the use of QE in the US will be explored in more detail in another article; this article will look at how QE works, when and where it was developed, why it's used and what the perceived risks of its usage are.

Although the theory, which I shall explain shortly, is quite straightforward, QE is fairly complex when applied to and analysed in the real world. The reason for this is that it depends upon what Keynes referred to as 'animal spirits', whether other countries are also using QE and how clear the channels which QE works through are, among other factors which can be difficult to predict and influence. That's one of the reasons why predicting the success of QE has been difficult in the past and why many people believe that QE has not been an effective policy tool at all.


What is quantitative easing?

QE is as a policy measure used by a country's central banking institution (e.g. the Bank of England in the UK and the Federal Reserve Bank in the US) to stimulate the country's economy by boosting its aggregate demand (total demand for goods and services in the economy) during times of recession and deflation. Its origins are unclear: some attribute its creation to the famous British economist John Maynard Keynes (1883-1946), others to the Bank of Japan in the early 2000s. Let's look at the theory behind the requirement for and application of QE.

 

The main tool of a central bank: its inter-bank interest rate


Normally the tool that a central bank implements to boost aggregate demand is the interest rate, which it lowers in order to increase consumption, investment, and export levels and reduce levels of imports. (If you're an economics student, you'll notice that this comes from AD = C + I + G + (X - M).)

Here's a brief summary of the way interest rates work. When the central bank reduces its interest rates, the commercial banks it lends to can borrow money at cheaper rates. This reduction in the rate of interest should result in banks lending more money to the public and to firms, who then spend that money in the economy, resulting in an increase in consumption and investment.

In theory, export levels also rise (and import levels fall) because of the impact interest rates have on exchange rates. If a country's central bank sets a low interest rate, the country's currency provides lesser returns to its holders, and so demand for the currency falls, as people buy amounts of other currencies instead because they have higher interest rates. As the demand for the currency falls, so does its value, which means the country can buy fewer goods with its currency but can export more, as its exports have become cheaper.

So that, in a nutshell, is the way that interest rates work to tackle a recession or deflation. But then why does QE ever come into play?

Why use QE at all?


The problem is that nominal interest rates cannot fall below zero. So if the lowest interest rates aren't creating the much-needed boost in aggregate demand, other (more unconventional) policy measures need to be used. One of these measures is QE.

Another reason why QE is used relates to the equation: GDP (Gross Domestic Product) = Money Supply  x  Velocity of Money (the average frequency with which a unit of money is spent in an economy). QE is thought of as a viable solution to the problems created by low consumer and investor confidence (low velocity) as it is a way of greatly increasing money supply. The theory is that the increased money supply should increase growth (GDP) and restore confidence so the velocity of money increases as people increase their spending. At this point, since the velocity of money is at a high level again, the use of QE can be discontinued without damaging the prospects of growth.

Okay, so how does it work?


The Bank of England has explained how QE works in this short video. It's extremely clear and has subtitles, so is simple enough to understand, even if you're not an economics student.

Before you start watching, I'll provide you with a bit of detail on some jargon so everything makes more sense when you watch the video:

  • Bonds are essentially loans which investors make to the bonds' issuers. Bonds are issued by governments, corporations and others entities in order to gather enough money to finance projects. In exchange for the loan investors are given interest (the bond's 'coupon'). There are many different types of bonds, and a government bond is known as a gilt.
  • A bond yield is the rate of return on a bond, and since the interest rate of a bond is generally fixed, the yield changes to keep the return on the bond fixed even as the value of the bond changes. This means that as the value of the bond increases, the yield decreases, and as the value of the bond decreases, the yield increases. In reality, bond yields can become quite complicated, but the explanation given above is sufficient for the purposes of the video.
  • The 2% inflation target mentioned in the video is specific to the Bank of England. Some countries may have the same target, but many have different targets. The most important role of the Bank of England (as set by the Chancellor) is to keep inflation at the 2% target in the medium term, which is why the video keeps referring to this target.


If you're on a mobile device and can't see the video as part of the article, here's the link to it on YouTube: http://youtu.be/J9wRq6C2fgo

 

Surely there must be some risks... What about inflation?

In theory QE can be reversed by the central bank selling the assets it purchased, thereby withdrawing money from the system. Inflationary pressures have been so small in the countries which are using QE that inflation doesn't seem to be too much of a problem. However, there are major issues involved with the usage of QE, many of which have been outlined in this fantastic article by Nouriel Roubini on the Project Syndicate website. Some of the problems involved with applying QE to the real world were mentioned earlier on in this article. The next few articles will extend those ideas and explore Nouriel Roubini's thoughts (as well as the thoughts of others on the subject of QE) in relation to the use of the policy in particular countries.


The next article in the series will look at the use of QE in the United Kingdom: how it was implemented; the reactions to its use; how successful it has been; and whether the Bank of England should continue with its current rate of asset purchasing.


4 comments:

  1. This post is very helpful for people who are into business sector.

    ReplyDelete
  2. You have explained the term Quantitative Easing very well. Great post!

    ReplyDelete
  3. This is really informative and interesting.

    ReplyDelete

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