ABSTRACT 3
INTRODUCTION
Background 4
Information Sources 4
Limitations 4
ANALYSIS
Quantitative Easing 5
Third Round of Quantitative Easing 7
Fiscal Cliff 8
European Debt Crisis 9
CONCLUSION 12
REFERENCES 13
Abstract
In is an analysis of the government’s role in the economy is presented. The articles from Economist.com namely, The Federal Reserve launches QE3 and The ECBs Bond-Buying Plan were analyzed in light of the theories and principles in Economics.
The themes of the two articles focused on the two Central Banks’ (the Federal Reserve and the European Central Bank) attempts to stimulate their respective economies through the use of ‘unconventional’ monetary tool, i.e., open-ended bond purchases to drive down the interest rates also known as quantitative easing. Though the Fed and the ECB have used the same monetary tool to affect economic activity, the goals were different: the Fed aims to boost the economy’s output while the ECB aims to save the euro.
Introduction
Background
In this paper, an analysis of the government’s role in the economy is presented. The articles from Economist.com namely, The Federal Reserve launches QE3 and The ECBs Bond-Buying Plan were analyzed in light of the theories and principles in Economics.
This paper attempts to answer the question: What economic theories and principles can be applied in explaining the ideas presented in the two chosen articles? In answering this, the report will look into the theories and principles in Macroeconomics.
Information Sources
The sources of information to present a thorough analysis are the journals and books accessed from the community library and online sources.
Limitations
The limitation of this report lies is in the use of sources. Specifically, it is limited on the use of secondary sources such as books and journals. No interviews were conducted.
Analysis
Quantitative Easing
I have chosen the following articles from The Economist: The Federal Reserve launches QE3 and The ECBs Bond-Buying Plan. The themes of the two articles focused on the two Central Banks’ (the Federal Reserve and the European Central Bank) attempts to stimulate their respective economies through the use of ‘unconventional’ monetary tool (i.e., open-ended bond purchases to drive down the interest rates also known as quantitative easing). Though the Fed and the ECB have used the same monetary tool to affect economic activity, the goals were different: “the Fed aims to boost the economy’s output while the ECB aims to save the euro” (The Economist, 2012).
I am interested in exploring how monetary policy affects the economic activity of a country. The Central Bank has three conventional monetary tools at its disposal, namely “buying/selling of government bonds through open-market operations, imposing minimum reserve ratio to banks, and the discount rates” (Dornbusch, Fisher, and Startz, 2003). The Central Banks often use the open-market operation to alter the monetary base and thus, the money supply. How will the change in money supply results to a change in the rate of interests? According to the theory of liquidity preference, “changing the money supply (supply of real money balances) alters the interest rate” (Dornbusch, Fisher and Startz, 2003). Specifically, the Central Bank’s buying of bonds from the public increases the real money balances, resulting to the increase in money supply (shift of the supply curve to the right). This leads to the fall in the rate of interest.
A different scenario happens when Central Banks use quantitative easing. This unconventional monetary tool works in two ways, theoretically. First, the Central Bank’s purchasing of financial assets from private institutions like commercial banks using newly created money results to increases in the excess reserves of banks. This in turn makes financial assets’ price to rise and the yield to fall. The graph below further supports this analysis. The expected return on bonds is equal to its yield to maturity and is given by the equation: i=Rete=(F-P)/P. Suppose the face value of the bond is $2000, with 1 year maturity. Computing for the expected return at various prices gives the following values:
Second, buying of financial assets by the Central Bank from the commercial banks increases the bank’s cash available money for lending. Increase in the supply of loanable funds decreases the interest rate of borrowing that tends to encourage investment activity in the economy (Dornbusch, Fisher, and Startz, 2003).
Looking at the big picture, using the quantitative easing is obviously aimed at increasing lending and spending by the public. As what Keynes said, lower interest rate stimulates borrowing of the private sector for investment. In turn, increases in investment spending results to increase in the aggregate demand that leads to increases in national output (that is more than the increase in aggregate demand because of the multiplier effect).
Third Round of Quantitative Easing (QE3)
QE3 or the third round of quantitative easing is a central bank (i.e., Federal Reserve) open-ended bond-buying policy directed towards lowering the interest rates and mortgage rates to stimulate demand in the economy. The QE3 in the US that started on September of this year involves buying of mortgage-backed securities (MBS) worth $40 billion every month (Censky, 2012). This is done by injecting a pre-determined quantity of newly created money in the economy through the purchase of debts (bonds) from banks (Irwin, 2012).
As the government buys MBS the supply of debt decreases resulting to increasing price of bond. Increasing bond price implies decreasing expected return on bonds and/or interest rate. The decline in the cost of borrowing has the wealth effect to the consumer, hence, encouraging them to spend more. The increase in the spending behavior of consumers sparks increases in commodity prices.
The value of the country’s currency is also affected by the QE3. The injection of newly created money to banks increases the quantity of money in the economy resulting to a drop in the interest rate. In effect, demand for dollars decreases, and hence the depreciation of the currency. Nevertheless, decrease in the value of dollar relative to other currencies makes the exports of the US to become very attractive in the foreign market. The increase in export together with the increase in investment (because of lower cost of borrowing) and consumer spending enhance growth in the gross domestic product (GDP) of the economy.
Moreover, in relation to employment, because of the reduced cost of borrowing, this entices businesses to borrow funds from banks to increase investment spending. The rise in spending of the business sector is viewed to help increase employment (thus, lower unemployment) by creating jobs in the economy.
Also, inflation is more likely because the demand-inducing policy encourages spending in the economy.
The increase in the demand for housing drives up the housing price. Housing sales and buildings also increases as the mortgage rates decline.
Fiscal Cliff
Fiscal cliff refers to the expiration of the combined tax cuts (such as 2001/2003 Bush tax cuts, 2009 stimulus, payroll tax holiday) and government spending cuts on December 31, 2012, and if not remedied, will have the dramatic effect of bringing the economy into a recession. The cliff refers to the immediate disaster that will immediately happen at the beginning of 2013. Upon expiration of the current policy, the combination of spending cuts and higher taxes is believed to reduce the fiscal deficit (, 2012). However, this will have the effect of reduction in GDP by 4% in 2013 resulting to a negative growth, and hence, recession.
Increases in tax reduce the disposable income of households, and therefore the consumption spending. This results to a drop in the consumption spending in the aggregate level and therefore a drop in aggregate demand also. Reduced government spending further reduces the level of aggregate demand. Decreases in the aggregate demand because of the above-mentioned changes shifts the AD curve to the left, inward. The equilibrium price is now lower as well as aggregate demand. The reduction in aggregate demand also decrease the national output (GDP).
Moreover, the declining price level discourages workers to produce more, and most likely will stop selling because of the declining prices. This decrease in production affects the labor market which further implies and unemployment increases also.
European Debt Crisis
The European debt crisis is the financial crisis that is being faced by the countries in the euro zone area. The crisis entails the struggle of some countries in the euro area to pay or refinance its government debt. In particular, five countries namely Portugal, Greece, Spain, Italy and Ireland were not successful in generating economic growth.
The increasing levels of debt of both the government and private sector around the world along with government debt downgrading in some of the countries in Europe caused fears among the investors of a sovereign debt crisis. What have caused the crisis? The property bubbles in several countries resulted to rising private debts that were transferred as sovereign debt due to bailouts made by banks and the government in response to post bubble slowing economies. Meanwhile, the unsustainable public sector wage and pension commitment led to the increase of sovereign debt in Greece. All in all, the structure of the euro area as a monetary union but with differing tax and public pension rules contributed significantly to the European debt crisis that crippled the ability of the European leaders to respond to the situation. A significant amount of sovereign debt is owned by European banks. In 2010, the leading European countries implemented a series of financial support measures including the EFSF or European Financial Stability, and ESM or European Stability Mechanism in response to rising and intensified concerns about the crisis.
On the part of the European Central Bank, it has implemented monetary policy aimed at lowering the interest rates. Cheap loans were made available to ensure the flow of money among European Banks in the region. Moreover, ECB also provided support to all the euro countries that were under the sovereign state bailout and financial support measures by lowering the OMT or Outright Monetary Transactions.
Conclusion
The articles from the The Economist: “The Federal Reserve launches QE3” and “The ECBs Bond-Buying Plan” were the focus of analysis. The themes of the two articles focused on the two Central Banks’ (the Federal Reserve and the European Central Bank) attempts to stimulate their respective economies through the use of ‘unconventional’ monetary tool. Though the Fed and the ECB have used the same monetary tool to affect economic activity, the goals were different: the Fed aims to boost the economy’s output while the ECB aims to save the euro.
References:
The Economist. “The ECB’s bond-buying plan” September 15. 2012. Accessed from
The Economists. “The Federal reserve launches QE3”. September 13, 2012. Accessed from .
Dornbusch, Fisher, and Startz (2003). Macroeconomics. Mcraw-Hill, Inc..
Crook, Clive, 2012. “The Fed’s Best Rationale for QE3”. Bloomberg, Sept 18, 2012. Accessed from
Irwin, Neil, 2012. “Is QE3 working? What the markets are telling us about the Fed’s move” The Washington Post, September 24, 2012. Accessed from
Censky, Annalyn, 2012. Federal Reserve launches QE3. September 13, 2012. Accessed from
Swann, Ben, 2012. “Reality Check: What is QE3? And What Does It Mean for The US Economy?” September 20,2012. Accessed from
Q&A: The US Fiscal Cliff. BBC News Business. November 14, 2012. http://www.bbc.co.uk/news/business-20237056
