Quantitative Easing & Money Supply Management by Central Banks
Posted: Monday, 18 August, 2014. | By: Equipoise Bot
Quantitative Easing (QE) is a term very often in the news in recent times. Let us take a look at the what, why, how and when of it:
What it is:
It is a monetary policy that is used by governments to increase money supply. It is an unconventional system and is usually used only when the conventional methods of increasing money supply have become ineffective. It was first used by the Bank of Japan in early 2000’s to fight domestic deflation. More recently, it has been employed by the USA, UK and the Eurozone during the financial crisis of 2007-2010.
Why and when it is done:
Central Banks attempt to increase money supply in poor economic conditions when spending is low. There are various methods to accomplish the same, one of which is quantitative easing. Quantitative easing is sometimes viewed as a last resort measure when the more accepted methods of increasing money supply have become ineffective. It is generally employed when the interest rates are near 0% and have failed to produce the desired effect.
How it happens:
It is implemented by the central bank purchasing financial assets such as government securities or other securities from the banks and other public/private institutions with the newly generated money. This floods the targeted institutions with capital and hence increases the money supply. It is thus an attempt at driving up spending and hence consumption in situations when even a near 0% interest rate fails to elicit spending (the economy is in a liquidity trap).
Risks & Questions on effectiveness:
- More money enters the system without a corresponding rise in the amount of goods available. This will eventually lead to higher prices i.e., inflation. This nature of generating more money without more goods leads to quantitative easing sometimes being referred to as “printing money”.
- Increasing the money supply tends to depreciate the concerned currency’s exchange rates versus others. This directly harms creditors and holders of the currency as the real value of the currency decreases. Also, importers will be harmed as the cost of imported goods will be inflated by the depreciation of the currency. This could drive up prices of imported goods sharply.
- There is always the risk that the new money could be used by the banks to invest abroad and in asset classes like emerging markets, commodity-based economies, commodities themselves and non-local opportunities rather than to lend to local businesses.
QE could thus prove useless unless it is combined with effective policy measures in other areas.
Illustration by the Bank of England:
- Export-led versus Import-substitution industrialization: Industrialization is a crucial stage of development in an economy. After the industrial revolution in Europe, the now advanced western economies went through the slow process of innovation and industrialized over a longer period of time. However, the late industrializing economies have a choice of policies to approach this issue. The inward-looking strategy of import substitution, or the outward-looking strategy of export-led growth.
- Export-led industrialization is one in which an economy focuses on goods it can produce cheaply compared to other nations, and export these goods. The so-called 'Asian Tiger' economies have adopted export-led substitution for their growth. This has popularized this strategy for pursuing development.
- The philosophy is to exploit ‘comparative advantage’ that a country has. For example, India and China have a distinct advantage over several other countries when it comes to labor-intensive processes, since labor is relatively cheap in India and China. This is what is meant by comparative advantage – to be able to produce cheaply due to a unique situation. Countries can choose to export either: 1) Manufactured goods or 2) Raw materials. The problem with exporting manufactured goods for a newly industrializing economy is that it is competing with developed economies who have highly efficient processes for manufacturing. However, the problem with exporting raw materials is that the ‘Terms of trade’ will deteriorate rapidly over time for the exporting country. By terms of trade we mean the amount of imports the country can make for a fixed quantity of exports.
- When a country chooses to adopt export-led growth the policies are geared towards specialization and exports. This makes the country vulnerable to fluctuations in the demand of the exported product, or specialization of that country in the world market.
- Import substitution industrialization, on the other hand, aims to reduce foreign dependency by encouraging certain industries to produce domestically what was earlier being imported. Usually the basic necessities such as food and energy are promoted first. The argument called ‘infant industry’ argument which forms the basis of this approach is that to set up new industries which are to compete with established competitors abroad, there has to be protection given to them in their early stages. The concept comes from intention to develop the local economy, by making sure not much money flows outside by means of imports, but money flows inside both through exports and investments in industry.
- This approach gained popularity in the 50s and 60s, but the execution was a failure in many latin American and Asian countries, mainly because they could not protect their ‘infant industries’ effectively, and their processes being inefficient compared to the developed world, meant not being able to compete on a global level.
- Although dependence on foreign countries is reduced and effects of global economic downturns are minimized in this approach, there is an argument that the infant industries developed are inefficient. Another disadvantage is that the tariffs on imports are high, and lobbying by the domestic firms may increase and reduced competition may mean failure of market structure.