Quantitative Easing

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Understanding economic policymaking

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IE Business School

Understanding economic policymaking

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Cours 1 sur 3 dans Specialization Globalization, Economic Growth and Stability

This is the first of the three courses part of the Globalization, Economic Growth and Stability Specialization. This course will employ a non-technical approach to analyze how governments use policy to influence a country's economy. Upon completing the course you should be able to discuss national debts and deficits, examine fiscal and monetary policy and their appropriateness to the situation of an economy, and anticipate the results of fiscal and monetary policies and structural reform on a country. These concepts will give you the tools to develop your own position in many current economic debates, such as fiscal stimulus vs. austerity, the merits of quantitative easing, the need for higher interest rates or the future growth path of many modern economies.

À partir de la leçon

Policymaking in the Wake of the Financial Crisis

You are now in the last module of our Understanding Economic Policymaking course! Having reviewed the theory behind economic policymaking, we devote the last module to discovering what policymakers are actually doing in the leading developed countries of the world. We will discuss whether interest rates have been appropriate in a group of countries, and what the consequences are if they are not. We will also discuss quantitative easing, the main “unconventional” monetary policy, and anticipate some of its consequences. We will have a look at deficits and debt in some countries and use the tools to determine whether they are problematic; we will analyze the “austerity” policies applied in many European countries; and we will have a look at the combination of fiscal, monetary and structural policies being used in Japan, dubbed “Abenomics”. We´ll also consider the perils of policymakers´ aggressive pursuit of growth at a time when it is becoming more elusive. The final exam will have questions from this module and from each of the previous modules, so you can study your earlier quizzes to prepare. Good luck as you complete the course! I´ve enjoyed getting to know you a little. Warm regards.

Quantitative Easing3:36

Fiscal Policy in the Real World: When is Debt Too High?11:35

Policy and the Eternal Pursuit of Growth5:26

Rencontrer les enseignants

Gayle Allard
Professor
Economics

[MUSIC]

Let's tackle a different question then, related to monetary policy.

What happens if interest rates can't be low enough?

We've looked at what happens when they're too low, but

let's look at situations where interest rates can't go low enough.

So, here I've got a slide [COUGH] showing what's happened with the crisis.

And, these are the interest rates that are set, that are targeted

by the ECB, and the interest rate's targeted by the FED, okay?

So, you can see what's happened to those interest rates since the crisis broke.

We know the financial crisis, so you know, it was

it kind of started snowballing, the first event is in 2007.

2008 is when things really go very wrong.

So, you can see the Fed which is the

red line began to cut interest rates very, very quickly.

Alright.

And, it went down, all the way down to 0.25.

And it was there by 2009.

And then it stayed there.

Well, there's a clear reason why [LAUGH] it

stayed there, because you can't go below zero.

You can take your interest rates to zero,

but you can't have them be negative, right?

So the Fed took interest rates down as far as it could

at the moment of the crisis, but it couldn't go any further.

Now, we can see the ECB.

It came down slower with interest rates.

It got a little concerned about inflation there at the end of 2011,

brought them up, but now it also is almost all the way down.

Okay?

And, the crisis continues in Europe.

So, what do you do if you can't take interest rates

down any further, and you continue to be in a recessionary gap?

Let's look at another example.

This next slide shows Japan.

And here we can see, in Japan, now their crisis was in, started in the 90s.

They had a domestic banking crisis, that

was followed by the southeast Asian financial crisis.

Then, they sort of started to recover.

And then, the global financial crisis came.

So, you can see, here we've got some different interest rates.

So, we can compare them here.

But, you can see that their rates went

down to zero very quickly and stayed there.

Looking at the, the nominal call rate or the nominal discount

rate, you can see they went all the way down to zero.

Now, the real rates, the ones that go

negative, are subtracting inflation from those nominal rates.

But, normally, a central bank would not set a negative interest rate.

So, you can see, they went down to zero.

They came up just a little bit in the period the

early 2000s, when things were looking a little better for Japan.

They went down again and stayed at zero after that.

So, when you've gone to zero, you've gone about as far as you can go, right?

As they say.

You, you can't go any further.

What then does a central bank do if it still needs to stimulate the economy,

as in the case of Japan, which has been in a very long recessionary gap.

Or, the case of the United States or the ECB or the Bank of England where rates

were as low as they could go, and the economy still needed an expansive policy.

Well, the, one of the solutions that authorities have devised in this period

of the financial crisis, is something that we call quantitative easing.

Now, quantitative easing simply means, if we

think of that transmission mechanism for monetary policy.

Remember, we start by increasing the money supply for an expansive monetary policy.

We start by increasing the money supply.

This is the only thing central bank can actually do.

This should cause the interest rates to go down.

That then should cause investment to go up.

Which then would cause aggregate demand and, hence, GDP to go up.

That would be our cause effect

chain, our transmission mechanism, for monetary policy.

But what happens if the central bank is increasing the money

supply as it knows it should and interest rates won't go down?

Or, what if, as we just observed, it's increasing

the monetary, the money supplies, it knows it should.

Interest rates have gone down, but they've gone as far as they can go.

And, we're still not seeing more investment

and therefore more aggregate demand in GDP.

We talked in an earlier session about

how sometimes this transmission mechanism breaks down.

And you can't get your money supply policy over

here into the real economy, more aggregate demand, more GDP.

Well, one of the things that central banks have started to

do, and this was started by Japan in their long crisis, was

to say, okay maybe the reason that this money is not

getting over there to the real economy is the financial crisis itself.

Banks are afraid, they're lacking liquidity, they look at

their balance sheets, they don't like the way they look.

And so, whenever the central bank provides liquidity to them through open

market operations, they take the money and they just hold onto it.

They keep it in their reserves, because they're worried about the future.

So, what central banks, beginning with the Bank of Japan,

said was, alright, if they need money to feel comfortable.

In order for the transmission mechanism to work, lend the

money, somebody spends it, we go to GDP, let's just

create a lot of money until banks finally have enough

reserves, enough cash, that they feel comfortable beginning to lend again.

So, that is what quantitative easing is.

It's where the central bank carries out very aggressive open market operations.

Selling many, or excuse me, buying many more bonds than

usual, and paying for them with much more cash than usual.

So, that the cash gets into the commercial banks, and they begin

to have enough liquidity that they can eventually start to lend money.

Well, this slide here shows what quantitative

easing has looked like in different countries.

And, we can see, actually the slide starts

after Japan was winding down its quantitative easing.

So, you can't really see the Japan effect, except that you

can see the curve for Japan, the red curve, is very high.

These curves measure, it says central bank assets, as a percent of GDP.

That means the central bank, how much does it hold

on its balance sheet of bonds, and other things, right?

But, mainly it's the bonds.

If the central bank is buying a lot of

bonds from the banking system and paying for them

with lots of cash to try to give liquidity,

then you will see the balance sheet growing, alright?

And, so you can see the Japanese balance sheet, you

can see central bank assets were 30% of Japanese GDP.

That's higher than any other country.

And, then you can see, they kind of wound down their quantitative easing.

And so, the Japanese curve is less interesting right now.

But you can see down at the bottom, you can

see the United States, and you can see the U.K., alright?

Both of them down there at about 7% of GDP.

That would be how much all the reserves of the

central bank were, bonds and the other things that they hold.

Now, you can see in 2008, suddenly that

number jumps dramatically for both of those countries.

In the U.S., it goes up to about 15% of GDP.

In the U.K., it goes up above 20% of GDP.

What's going on is both of these countries are doing quantitative easing.

They're buying lots and lots of bonds from commercial banks.

Giving cash for them, trying to get this transmission mechanism to work,

and that additional cash to work its way through into the real economy.

And, at the same time, you can see their

balance sheet growing with these additional bonds that they've bought.

And, you can see that both of them have stayed up at there, those high levels.

There hasn't been any winding down of

quantitative easing, as there was in Japan.

[BLANK_AUDIO]

Now, this chart ends in 2012, but one of the things you see in

the papers all the time, and I hope this will help you to understand.

Is news about whether the Fed is going to taper.

The term they use is taper its quantitative easing program.

Currently, the Fed is buying $85 billion

in bonds every month from commercial banks.

That's a lot of bonds.

That's a very big number.

And, we know that in open market

operations, you buy bonds from commercial banks.

You put cash into the economy if you want

to shift the money supply out to the right.

But, $85 billion is much more then the Fed

has ever bought from banks on a regular basis before.

So, the Fed has said it's going to continue doing this until

the unemployment rate is at a reasonable level in the United States.

Maybe 6.5%.

And the new Fed chairman says she will continue with this program.

But, markets are always watching for some

sign that the Fed will taper quantitative easing.

Meaning it's op, it's purchases, which

currently are $85 billion, will decline, right?

When that happens a lot of things could happen in financial markets, right?

There could be an effect on stock markets.

There've been a lot of discussions about what this actually does.

What's clear is that quantitative easing has been a great benefit to governments.

Because, again, if you think about our primary and

secondary markets that we talked about some time ago.

When the Fed is buying huge amounts of bonds in secondary markets

through commercial banks, actually, what's happening

is that the interest rate is dropping.

And so, when that low interest rate reaches the government in

a new option, it pays very little to finance its borrowing.

So, this is great for governments.

It saved them lots and lots of money.

It's maybe not so great for financial institutions,

for pension funds, specifically, or insurance funds, which

put money in bonds to get a return, and they're not getting much of a return.

It's a mixed bag for households because households save some money.

They're getting not very good returns on their savings.

They also borrow some money.

They're borrowing at low rates.

So, it's been a kind of a mixed bag for households.

It's been negative for foreigners because U.S. bonds

are attracting so much money and paying so

very little returns that foreigners that hold bonds

are, are not benefiting very much from those investments.

So, quantitative easing is one of the big topics of our day, and

what I want you under, to understand here is why it was done.

It was done because the transmission mechanism had broken down.

Interest rates could no longer go any lower.

And, monetary authorities are trying to find a way to exercise what tools they

have and influence the real economy and bring us out of our recessionary gap.

[MUSIC]

[BLANK_AUDIO]

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