Fiscal, Monetary and Supply-Side Policy: Question 8

Worked solution

Part (a): How quantitative easing increases the money supply

With its policy interest rate already close to zero, Halveston’s central bank cannot stimulate the economy much further simply by cutting interest rates, so it turns to quantitative easing. The central bank creates new money electronically and uses it to buy government bonds held by commercial banks and other financial institutions. This directly increases the reserves and liquidity that commercial banks hold, and by buying large quantities of bonds it also tends to push bond prices up and long-term interest rates down. With more reserves available and returns on holding bonds lower, commercial banks have both the ability and the incentive to lend more to households and firms, increasing the amount of money actually circulating in Halveston’s economy through new loans, mortgages and business credit.

Part (b): AD/AS effect, and why output responds more than prices

If banks do lend more, households borrow to fund extra consumption and firms borrow to fund extra investment, so both C and I rise. This shifts Halveston’s AD curve to the right. Using AD/AS analysis, a rightward shift in AD raises both the equilibrium price level and the equilibrium level of real output.

However, because Halveston is in a recession, it has substantial spare capacity (unemployed workers and idle machinery that firms can bring back into use. When AD rises while the economy operates well short of full capacity, firms can expand production by using this spare capacity rather than by bidding up scarce resources, so output can rise with relatively little upward pressure on costs and prices. This means that, in Halveston’s specific situation, the rightward shift in AD is likely to raise real output more than the price level) the opposite of what would happen if the economy were already close to full capacity.

Part (c): Why quantitative easing might not fully succeed

Quantitative easing relies on a chain of behaviour that is not guaranteed to work as intended. First, commercial banks might respond to a recession by becoming more cautious lenders, choosing to hold the additional reserves the central bank has supplied rather than lending them out, especially if they judge that many borrowers are a higher credit risk during a downturn. Second, even where credit is cheap and available, households and firms may lack the confidence to take on new borrowing when the economic outlook is uncertain. Households may prefer to save rather than spend, and firms may postpone investment until demand recovers, a pattern sometimes described as a “liquidity trap”.

If either of these responses occurs, the extra money supply created by QE sits in the banking system rather than flowing through into extra consumption and investment, so Aggregate Demand rises by less than the central bank intended. On the other hand, QE has, in various real economies, succeeded in supporting lending and asset prices during downturns. Overall, whether QE falls short of its intended effect on AD depends on the confidence of banks and borrowers at the time, and it is reasonable to conclude that QE is not a certain or fully reliable way of raising AD by a precise, predictable amount.

Final answers

• (a) QE increases bank reserves and liquidity by having the central bank buy bonds with newly created money, which is intended to encourage more bank lending
• (b) AD shifts right; both the equilibrium price level and equilibrium real output rise, but with substantial spare capacity, most of the effect falls on real output rather than the price level
• (c) QE can fail to raise AD by the intended amount if banks hoard reserves instead of lending, or if low confidence means households and firms are unwilling to borrow and spend even at low rates