Exam answer: Monetary policy and economic growth | tutor2u Economics
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Exam answer: Monetary policy and economic growth

Here is a good student answer to this question: "To what extent is monetary policy the most effective way of stimulating economic growth? Refer to at least one example of a developed economy in your answer."

Monetary Policy relates to the policies employed by a central bank, currency board or other regulatory committee that affect the cost and supply of money and the policies largely fit into two categories: ‘conventional’ and ‘unconventional’ monetary policy.

Conventional monetary policy includes setting policy rates (the interest commercial banks earn when keeping their money with the central bank), possible intervention in the currency markets for example with managed floating (Zambia, India, Brazil), crawling peg (Jamaica, Croatia) or fixed peg (Bahrain, Denmark, Qatar) exchange rate systems and measures to affect credit creation for example changing the amount of cash that banks are required to keep in their vaults.

Central banks can also use unconventional methods, and many have done so since the Global Financial Crisis (GFC) in 2008.This includes Quantitative Easing (QE) whereby a central bank ‘creates’ money (digits on a screen) and uses it to buy up government debt from commercial banks, this pushes up the price on the bond which reduces long term interest rates in the economy and also improves the balance sheets of commercial banks in an attempt to stimulate household lending. The Bank of England’s QE programme lasted between 2007 and 2012, and in this period they created £375 billion worth of new money and the US Federal Reserve between 2007 and 2015 bought $3.7 trillion worth of government bonds.

Qualitative Easing (QE2) also fits into the category of ‘unconventional’. This is where a central banks extends QE to buying up the debt of corporations to improve their balance sheets which will hopefully stimulate investment. A more recent policy that is being tried out are negative interest rates. This means that commercial banks have to pay the central bank to keep deposits and so the hope is that they will lend out the money instead for example the Danish Central bank has imposed a negative interest rate since 2012 and yesterday the ECB announced it had dropped its deposit rate from -0.2% to -0.3%.

Since 2008, expansionary monetary policy has been a tool used by most of the developed world to stimulate their economy and the first way in which it has been employed is through a sustained period of ultra-low nominal interest rates. For example, the policy rate in the UK has been 0.5% since March 2009 and are likely to stay that low for at least another year or so with Mark Carney, Governor of the Bank of England saying last month that “now is not the time to raise interest rates”.

The first effect of low interest rates is that it should cause a depreciation in the exchange rate as for example the UK becomes a less profitable place to store money and so ‘hot’ money flows are reduced. This causes the relative value of the pound to fall and as the diagram shows between May 2008 and May 2009 the sterling fell by 25% against the dollar. The pound has continued along this course and has also fallen 4% since the start of this year. A depreciated currency makes importing relatively more expensive and British exports relatively cheaper. This helped the recovery of the UK economy and between January 2008 and January 2010, UK exports increased by around £3 billion and the UK’s balance of trade increased by the same amount in that period. This means that the UK has reduced the withdrawal on its economy created by the (X-M) component of Aggregate Demand (AD), which helps to move it to a healthier level of GDP.

Statistic: Forecasted Bank Rate in the United Kingdom from 1st quarter 2014 to 1st quarter 2021 | Statista
Find more statistics at Statista

This effect does of course depend on the interest rates of other countries. In the period after the GFC, lowering interest rates was a common tactic for a developed economy and so the effect was not a large as desired for the UK economy. Furthermore, the extent to which domestic and foreign consumers expenditure switch to buy UK output does depend on the non-price competitiveness of UK goods such as their reliability and quality. Lower interest rates also attempt to have the effect of reducing the incentive to save, and therefore the savings ratio although this depends on deposit rates offered by commercial banks, not just the bank rate. The effect can also be outweighed by household fears of the economic climate and from January 2008 to July 2009, the UK savings ratio increased from-0.25 to 8.2%. Lower interest rates also makes borrowing cheaper, which can finance investment by firms and spending by consumers and the cost of credit falls. Mortgage costs tend also to fall, which means that homeowners are left with increased disposable income. Cheaper mortgages also tend to push up asset prices that may cause a positive wealth effect and therefore increased spending. However, both these effects only benefit homeowners and the percentage of UK homeowners reached its lowest point in 2014 for 25 years with only 65% of households being owner-occupiers. For those renting and trying to get on the housing ladder increasing house prices will increase their saving.

There are also some further limitations with low nominal interest rates. Animal spirits, the term coined by John Maynard Keynes to describe the fluctuating instincts of consumers and businesses in an economy tend to be lower due to the collapse in confidence that was experienced during the global financial crisis and for example in the second quarter of 209, business investment fell by 5.1% despite having low interest rates. Furthermore, as discussed, the effect on the UK balance of payments was limited due to the recession in the European Union who account for 50% of UK exports. Banks were also risk averse during the crisis and so were reluctant to lend and so the effect of increased availability of credit was limited. The UK experienced a low interest elasticity of demand whereby demand and growth were not as responsive as would have been desired to lower interest rates could sum it up.

Quantitative easing was another tactic employed by the Bank of England to stimulate economic growth and the bank created £375bn worth of new money in five years. The money is used to buy government debt from commercial banks with the hope that they will use this money to lend out to consumers. Consumers then can borrow money at low interest rates and use this to fund investment.

However, the effectiveness of the UK’s QE program was also limited with the Bank estimating that £375 billion worth of QE led to about 1-2% GDP growth. In other words, £375bn created just about £23-28 billion worth of extra spending in the real economy. The real economy contrasts with the financial economy that saw most of the rewards from QE. As the newly created money was used to buy government bonds therefore the money went directly into the financial markets, helping to boost bond and stock prices to their highest level, with the Bank itself estimating that QE boosted bond and share prices by 20%. The positive wealth effect created by this was limited due to the fact that 40% of the stock market is owned by 5% of the population. Furthermore, instead of lending money out, financial institutions used it to buy their own shares back to push up prices. Perhaps a better alternative could be and would have been ‘People’s QE’ whereby the Bank would create money and give it directly to the government who could then increase the G component of AD by injecting the money into infrastructure projects and so on (the ‘real’ economy).

Reverse interest rates are also a tool of monetary policy that has been used to stimulate economic growth. Denmark, Sweden, Switzerland, the European Central Bank and since last month Japan have decided to put a negative rate on commercial banks’ excess deposits with the central bank. The aim of negative rates for the Bank of Japan is to get banks to lend money out to businesses to support the country’s flagging economy and break free from deflation. Japan has experienced low inflation or deflation for almost two decades, which causes households and businesses to hold off spending, in the hope that prices will fall in the future.

Japan are also desperate for the value of the Yen to fall and this could be achieved if the negative rates help encourage an outflow of hot money. The value of the Yen has been appreciating against the dollar from a record low of 75 in October 2011 to 113.73 in March 2016. If Japan can reverse these fortunes then there balance of trade may well improved helping growth, they may start to reach their inflation target of 2% and bank lending to fund consumer spending and investment will improve. Although Japan operated a free-floating exchange rate, this use of negative rates to alter the yen is almost a move towards a managed floating system.

We have seen, especially in the UK that monetary policy, especially after the GFC can be an effective means of stimulating growth. However, I would argue that the effect of QE and low (and now even negative) interest rates did not help as much as central bank heads would have liked. Perhaps, in the case of the UK, having a seemingly contradictory monetary and fiscal policies didn’t help and perhaps increased government spending, through ‘People’s QE’ might have been the way forward. Not only does it increase the G component of AD but it also acts as a means to restore confidence, in a way that fiscal austerity did not. It arguably did the opposite. Therefore, I would argue that monetary policy does remain a good tool to stimulate growth but it works better in conjunction with expansionary fiscal policy.

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