Question

One of the repeated issues we have seen come up in multiple crises is the ineffectiveness of central bank policies, including lowering interest rates and quantitative easing. Explain why these policies were unable to either resolve the crisis or return the economy to its prior level of economic growth.

Answer 1

Central bank and its policy of low interest rates

The Central Bank is the institution which manages the currency and monetary policy of a state or formal monetary union and supervises their commercial banking system. In contrast to a commercial bank, a central bank has a monopoly on increasing the monetary base in the financial crisis. Most central banks have supervisory and regulatory powers to ensure the stability of member institutions, prevent bank runs and discourage negligent or fraudulent behaviour of member banks.

Central banks in most developed countries are institutionally independent of political interference. Yet, there is limited control of executive and legislative bodies.

Risk-free interest rates, usually set by a central bank, occur when the low interest rate scenario is long below the historical average. In the United States, risk-free rates are usually defined as the interest rate on Treasury securities. A particular form of low interest rates is negative interest rates. Low interest rates make borrowing cheaper. It shows a tendency to encourage expenditure and investment. This leads to high demand (AD) and economic growth. This increase in AD may also cause inflationary pressure.

In principle, the lower interest rate simply does:

Reduce the incentive to save. A small income from saving low interest rates. This low incentive to save will motivate customers to spend more than holding on to money.

Low borrowing cost. Low interest rates make the cost of borrowing cheaper. This will encourage consumers and organizations to borrow to finance more expenses and investments.

Low mortgage interest payments. The fall in interest rates will reduce the monthly cost of mortgage repayment. This will make employees more disposable and increase consumer spending.

Rising asset prices. Low interest rates make buying assets like housing more attractive. This will lead to an increase in housing prices and hence increase wealth. Increased wealth will encourage consumer expenses as confidence is high. (Wealth Effect)

Depreciation of exchange rate. If the UK lowers interest rates, saving money in the UK is relatively attractive (you can get the best income rate in another country). So the pound will cause the sterling to decrease in demand. The fall in exchange rates makes UK exports more competitive and imports more expensive. It also helps in increasing the overall demand

Analysts warn that zero or negative interest rates will "cause huge damage" to the economy in the long run, and the addiction to cheap erosion has become a problem as central banks around the world are on the path of rising low rates.

Spending is intended to give an incentive to spend rather than save negative rates, which will help the economy to shoot down and raise prices. Europe and Japan have engaged in negative rates to reduce the risk of inflation, which has had harmful effects over time, such as making debt payments heavier.

Central banks have direct control only on short-term charges, such as charges from financial institutions that keep deposits overnight in central bank books. But short-term rates are troubling the economy, which causes long-term rates to fall, which control supply and demand. In part, long-term rates of things, such as bonds or mortgages, are based on what short-term rates will be in the future.

Low interest rates also show a tendency to depreciate the value of the currency, as the demand for savers decreases when you switch to better-paid investments in other currencies. Deprecated currency can boost exports and make imports more expensive.

The trend of interest rates is "distorted" and can "poison" the business environment, said Young Hedrik-wong, a visiting scholar at Lee Kyuan Yu's School of Public Policy.

Low interest rates affect the profits of lenders because they reduce the margin suspense that banks can earn. In a negative interest rate environment, reducing rates to a negative area means lenders pay more to keep their extra funds overnight.

Central bank and its policy of quantitative easing

Quantitative easing is a form of non-conventional monetary policy in which a central bank buys long-term securities from the open market to increase monetary disbursement and promote loans and investment. Buying these securities adds new money to the economy and helps to lower interest rates by bidding on fixed income securities. It also expands the balance sheet of the central bank.

When the short-term interest rate is nearer or close, the normal open market operations of a central bank targeting interest rates will no longer be effective. Instead, a central bank can buy specific assets. Quantitative mitigation to give more liquidity to banks increases cash supply by purchasing assets using newly created bank reserves

The goal of monetary policy of any economy is to provide stability. That is why central banks were first created. Scholars believe that policies such as quantitative reduction work in the opposite direction. In the short term, they provide monetary stimulus and In the long run, they create monetary instability, which defeat the entire goal of being a central bank.

Disadvantages of Quantitative easing

Inflation

The central banks aim to keep inflation at a minimum. However, the policy of quantitation reduction is exactly the opposite. This is inherently inflationary, as this policy creates money and uses this money as reserves to increase the loan. There is no more empirical evidence of the level of inflation caused by quantitative mitigation. This is due to a relatively recent phenomenon of quantitative mitigation. However, monetary policy indicates that quantitative reduction is used in a depressed economy, so the first results of inflation are good because they will stimulate the economy. The subsequent results of such a stimulus will be difficult to control when the economy recovers. So quantitative mitigation will solve one problem but create another in the next few years. So this is only a temporary quick solution, not a long-term solution.

Interest Rates

The central banks aim to keep interest rates stable to some extent, like inflation. The central bank's performance is due to further fluctuations in interest rates in the economy. Stability that achieves strong consumer confidence creates a strong economy. On the other hand, if there is a big fluctuation in prices, users will not feel the same amount of confidence and the economy will be disappointed in the long run as users tend to delay costs and avoid purchases.

Quantitative mitigation policy reduces short-term interest rates. However, in the long run, this leads to inflation, which leads to a rise in interest rates, which is contrary to financial stability. Therefore, critics of quantitative mitigation believe that this is a disastrous policy that has negative effects on the economy.

Business Cycles

Many critics believe that quantitative mitigation is the culprit behind creating business cycles. They believe that reducing the quantity will easily create money in the economy. This money then reaches the lenders who want to lend at any cost. They compete to find borrowers. In this competitive process, they stop lending to people who do not get the loan first. Therefore, the policy of quantitative reduction first creates a leap, namely, an expansion phase where banks lend to all and all businesses grow.

However, later the same monetary policy leads to the assignment of banks. Because when the quantity is stopped, the money becomes tight. This causes banks to call their loans and as a result businesses start shrinking, i.e. recession. Therefore, the same policy of reducing quantitation has led to a surge in the economy and a recession.

Employment

Labour is associated with business cycles. The boom phase is witnessing massive job creation. Banks lend money to businesses easily, and then they use this money to develop and create jobs in the process. Therefore, the use of quantitative mitigation creates jobs for short periods. However, the economy will grow only after receiving cash injections from the central bank in this process. So, when the bond purchase stops, bank loans and businesses start to shrink. It is well known that as businesses shrink, they reduce the number of employees they can hire. As a result, people are fired, and therefore the level of employment decreases. Again, reducing the quantity will stabilize the labour rate. Instead, it was first raised and destabilized by falling.

Asset Bubbles

The abundance of money always creates bubbles in asset markets. High salaries and high profits always enter these markets, which raise the price of assets traded in them. Therefore, the policy of quantitation reduction leads to the formation of an asset bubble in the market. Again, the market, like the economy, combines with the growing monetary stimulus on a daily basis, and once this stimulus is stopped, people will start pulling money out of the market. Therefore, the policy of quantitation reduction will lead to an increase, a sudden fall in market prices and a huge transfer of wealth.

Therefore, the theory of quantitative reduction has not been tested relatively. There are great arguments on both sides of this theory. Some people believe it is extremely useful, others believe it is dangerous and can destroy the economy as a whole.

Summary

The Federal Reserve lowers interest rates to stimulate economic growth, as low erosion costs will encourage credit and investment. But when the rate is too low, they will result in excessive growth and subsequent inflation, reduce purchasing power and eliminate the stability of economic development and Quantitative easing is a form of non-conventional monetary policy in which a central bank buys long-term securities from the open market to increase monetary disbursement and promote loans and investment. Instead..... a central bank can buy specific assets.