Should Central Banks Abandon Their Expansionary Policies

Introduction During the recent global financial crisis, increased uncertainty of loan defaults resulted in reluctance of banks to issue loans. Among other reasons, this stagnation of the financial market worsened economic stability and contributed to the recession that economies worldwide are still fighting to overcome today. With the decline in consumer confidence and freeze up of the interbank market, the responsibility fell on central banks to take bold and drastic steps to correct the failing economy.

In our essay, we outline the expansionary monetary tools used by the central bank which include open market operations (OMO), cash reserve ratio, interest rates and quantitative easing (QE). We discuss the resulting effects on the economy and conclude by critically analysing the effectiveness of these policies. Contents Monetary Policy as conducted by the Central Banks Open Market Operations (OMO) Open market operations are primarily used to control interest rates and indirectly the total supply of money in the market. It can also control the targeted rate of inflation.

The Federal Open Market Committee (FOMC) implements monetary policy by buying and selling securities. To increase the money supply, they buy bonds to create credit in the market. So, expansionary monetary policy through open market operations includes buying bonds and securities from private banks. This injection of capital to banks enables them to provide loans to private individuals and businesses in the economy. With a higher availability of loans in the market, interest rates would be reduced. This leads to more borrowers have access to cheaper capital. Thus it leads to increased investments and stimulate growth.

Cash Reserve Ratio The reserve requirements (RR) are the minimum amount of assets that commercial banks are required to keep as reserves (R) with themselves or as deposits at the central bank (Minimum liquidity requirement). Altering RR affects money supply by affecting the money creation process that banks undergo as well as the monetary base. Central banks (CBs) can alter monetary base (H) by controlling the amount of reserves in the economy and hence CBs can have some control over money supply (M) via the relationship stated below. CBs alter reserves in the economy by altering RR. * H=R(reserves)+C(cash) * M={(c+1)/(c+b+e)}H.

* Where {(c+1)/(c+b+e)}=money multiplier * b=fraction of deposits held to make up the RR * c=fraction of deposits held as cash * e=fraction of deposits held as excess reserves During expansionary monetary policies, central banks will reduce RR by increasing the excess reserves . Commercial banks would have more assets to contribute to the credit creation process, which increases money supply. Once RR has been reduced, commercial banks can either choose to keep the newly attained reserves as excess reserves, or loan it out. By keeping the reserves in excess, it increases “e”, this result in a stagnant state of money supply.

They could also loan it out which decreases “b” resulting in an increase in the money multiplier. Interest Rates Toward the end of 2008, the Federal Reserve lowered interest rates to an all time low of a near zero percent in an attempt to encourage interbank lending in the overnight market (NYTimes, 2009). Similar steps were taken by the Bank of England in UK which by the end of the 1st quarter of 2009 reflected interest rates as low as 0. 5% (BBC, 2009). Taking the trade relationship between the U. S and China as an example, statistics show that overall trade between the two countries have increased fourfold from 2001-2008 (USCBC, 2011).

Instability in the U. S. economy hence will have a significant negative impact on the Chinese economy. The recession was not as severe in Asian countries in comparison to the Western countries, therefore the correctional policies implemented by central banks, though similar to the Federal Reserve and the Bank of England, were not as drastic. Returning to the example of China, the Chinese Central Bank decreased interest rates to an extreme matching that of the Asian financial crisis of 1997. (NYTimes, 2008)

However, as our focus lies with policies conducted by central banks, we will consider interest rates to collectively describe the federal fund rate and the discount rate. As interest rates fall, credit stringency and opportunity cost of borrowing falls. Banks then have incentive to take out loans and increase financial activity in an attempt to maximise profits. This results in the stimulation of the overnight and interbank market. In the midst of a recession, stimulation of the economy is part of the solution. However, over stimulation can prove to be a problem as it can lead to excessive economic growth which in turn can lead to inflation.

Massive cuts in interest rates to near zero results in a ‘liquidity trap’. This is where interest rates cannot fall any lower as they cannot be negative. It is depicted by the horizontal line of money demand in the graph. Monetary policy by setting interest rates is then ineffective and central banks need to adopt other methods, such as increasing money supply or quantitative easing which will be discussed in the next section. Quantitative Easing Quantitative easing (QE) is an unconventional tool the central banks use to stimulate the economy when other conventional monetary policy tools have been deemed obsolete.

Basically, it involves the central bank buying large financial assets with a pre-determined amount of new electronically created money. In a recession, when interest rates are close to zero, normal monetary policy methods such as buying and selling of short term government bonds (open market operations) can no longer lower the interest rates. As such, central banks conduct QE to increase the money supply, and hopefully stimulate the economy. QE is usually considered as a last resort to stimulate the economy. One of the ways the central banks conduct QE is, they purchase financial assets held by the banks.

By doing so, banks would now have more excess reserves, and it would be easier for banks to lend out money to economic agents within the economy. In the United States, the Federal Reserve also purchased US treasury bonds to decrease the yield on these safe assets. By doing so, the Fed hopes to induce commercial banks to look for profitable loans, and not only invest it in safe options such as the treasury bonds. By buying the assets or toxic bonds those commercial banks hold, and decreasing the rates on US treasury bonds, the hope is that banks will be encouraged to lend money once again, and kick start the lending cycle between banks and economic agents.

Critical Analysis of the Effectiveness of Monetary Policy In this section, we will discuss whether the above policies are effective in the real economy. Ultimately, the paper will discuss whether central banks around the world should abandon these policies, as they might lead to inflation. During a financial crisis, whether or not monetary policy is deemed effective, by abandoning monetary policy through disregarding the decrease of interest could be disastrous compared to future inflationary pressure.

By not conducting OMO or decreasing cash reserve ratio, interest rates would remain high. If interest rates remain high, access to credit remains difficult. As such, it would be harder for firms to invest further, and stimulate economic growth. As seen in the GDP growth rate graph above, in 2008, when the financial crisis hit, United States GDP experienced negative growth for almost 2 years, before potentially recovering from the crisis with a 2. 9% growth rate in 2010. Bear in mind that, when the financial crisis hit, the Federal Reserve reduced interest rates to nearly 0%, as mentioned in the interest rates section above.

Interestingly enough, even when GDP has shown signs of recovery, unemployment rate in the US remains at 9%, perhaps one could predict that unemployment rate should fall in the following year. Therefore, it remains a possibility that had the Federal Reserve not lower interest rates, our economy would still be in shambles. Looking at the graph above, after the financial crisis, inflation rate decreased tremendously till the end of 2009. However, beginning from early 2010, till this day forth, inflation rate has been fluctuating about 1% to 4%, and yet, does not show any signs of future inflation woes.

Therefore, it can be deduced that low interest rates will not necessarily lead to high inflation. In the Eurozone, following the global financial crisis, the ECB too, reduced interest rates from 4% to 1%. GDP growth responded well, following the ECB’s expansionary monetary policies which consisted of lowering interest rates by conducting OMO, lowering cash reserve ratio and so forth. Germany, France and Italy experienced positive growth rates in 2010, but Greece on the other hand, is still slumping in terms of GDP growth rate.

In the Eurozone, monetary policy seems to be effective in combating the recent global financial crisis. With regards to quantitative easing, announcing the printing of more money during an already battered economy may be a double-edged sword to the economy. This is because the news might be treated as an ominous sign and lead consumers to think that the economy has yet to fully recover. Ultimately, this could cause consumers to further lose their confidence towards the economy. Yet, with all the negative arguments against QE2, after it was implemented, GDP growth rate in the United States experienced a growth of 2.

9% in 2010. While there could be many factors that may have attributed to the result of higher GDP growth rate, QE2 may have been one of the reasons, or the stepping stone to stimulating the economy. Conclusion We have discussed how monetary policy is conducted by the central banks, mainly, the Federal Reserve, and the tools the Fed manipulates in order to stimulate the economy. Following the subprime crisis, the Federal Reserve took many steps to intervene, in hopes of rejuvenating the economy. Whether they have succeeded or not, the answer remains uncertain.

However, after analysing the policies and steps taken by the Fed, it is believed that, if the economy was left to fend for itself, and the Fed did not conduct expansionary monetary policy, the economy would have fallen into a deeper recession. In conclusion, the central bank should not abandon their expansionary monetary policies. As of now, GDP growth trend is showing positive signs of a recuperating economy, and inflation level is still under control. Perhaps, some central bank policies may be deemed ineffective at first, however, in the long run, the effects of such policies may finally bear fruit.

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