Quantitative Easing Essay

1243 words - 5 pages

According to an official publication (Bank of England, 2012), in the United Kingdom, “Quantitative easing began to be conducted in March 2009 following the intensification of the financial crisis after the collapse of Lehman Brothers and the associated sharp contraction in output”. The Monetary Policy Committee, which is a committee of nine experts that meets every month at the central bank of England to discuss the economy and decide how to set monetary policy, had decreased interest rates sharply. There were reductions of 3 percentage points in Bank Rate during fourth quarter of 2008 and a further 1.5 percentage points in early 2009, such that by early March 2009, Bank Rate had been ...view middle of the document...

The effect on a wider range of financial asset prices is more uncertain. Taking into account the estimated composition of household net financial assets, their analysis suggests an overall boost to UK households’ net financial wealth (which includes pension wealth) of about 16%.
The conventional way for policymaker to conduct monetary policy is by setting the base rate - the traditional policy instrument. Because it influences the price of credit and money, thus, has significant effect on inflation. When the central bank or the government is concerned about the risks of very low inflation, it cut the base rate. Lowering the base interest rate, which means reducing the price of central bank money, is intended to help to reduce the market rates, hence, boost investment, borrowing and spending. Additionally, central banks ordinarily operate monetary policy by buying and selling short-term debt securities to target short-term nominal interest rates. These purchases and sales of assets change both short-term interest rates and the monetary base - the quantity of currency and bank reserves in the economy. For example, the central bank buys short-term securities, expands the supply of money and decreases short-term real interest rates. This has impact on a variety of asset prices, including exchange rates and stock prices. Furthermore, economic decisions could be affected by changes in asset prices. Higher stock prices increase consumer wealth and make the issuance of new stock more lucrative. Therefore, consumption and business investment are directly stimulated. Domestic goods are more competitive compared with foreign goods because of a lower foreign exchange value of the domestic currency. And, once again, lower interest rates encourage borrowing for consumption and investment.
However, the interest rate cannot fall below zero and countries also do not want to get into trouble with deflation, when the inflation rate falls below zero percent (a negative inflation rate). The problem recognized here is called the lower zero bound. According to Bain and Howells (2012), “The reason that the zero lower bound to nominal interest rates poses a potential problem is that it seems to make it impossible to reduce the real interest rate in a recession below the rate of inflation prevailing at the time that the nominal rate hits zero. In the worst case, this could cause a vicious circle of rising real interest rates”. Assume that a country is on the edge of an economic depression, then, the interest rate and inflation rate are both zero. If the demand continues to decrease, the actual and expected rates of inflation become negative. At this point, the real interest rate begins to increase. Now, presume that there is a further deduction of demand in the economy because of the...

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