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Quantitative Easing in the Great Recession Case Solution

Solution Id Length Case Author Case Publisher
1091 1394 Words (6 Pages) Arvind Krishnamurthy, Taft Foster Kellogg School of Management : KEL782
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In March 2015, the European Central Bank adopted a quantitative easing program to convert the bundle of public debts to the private ones. The policy is expected to increase the purchases from €13 billion to as high as €60 billion. The central bank took this step to keep its grip on the inflation rate in the region. The bank also planned to buy securities and create money and channelize monetary ease in the economy. The ability of the central bank to convince the market that the policy can lead to serious effects on inflation, and unemployment can bring economic prosperity in the region (The Economist, 2015).

Stephen Williamson argued that QE can lead to deflation because when the government plans to implement QE, an investor will only be willing to buy if he expects that the value is going rise. This factor acts as a deflationary pressure on the economy. But there are a lot of skeptical statements regarding this argument (Carney, 2013). Economists also believe that the QE is not always able to reach the target of the inflation rate and it also distorts the expectations about the inflation in the economy (Dev, 2015).

Following questions are answered in this case study solution

  1. Provide a synopsis of the financial market impact of the QE announcements, considering:

  • The behavior of long-term and short-term rates,

  • Changes to corporate bond spreads, and

  • Inflation expectations.

  1. Consider the various impacts of QE1, QE2, and QE3, and identify the reasons for the differences in the market reactions to each of these three policy actions.

  2. Identify how QE may impact:

  • Different sectors of the economy (e.g., households, banks, corporations), and

  • Macroeconomic variables (e.g., inflation, bank lending, employment).

  1. What are the main costs of QE?

Case Analysis for Quantitative Easing in the Great Recession

Consider the various impacts of QE1, QE2, and QE3, and identify the reasons for the differences in the market reactions to each of these three policy actions.

QE1 results in lower mortgage rates and also provides a channel for financial activities and expands space for higher yields of the treasury. It also invites investment leading to economic growth (Krishnamurthy & Vissing-Jorgensen, 2011).QE 2 is very effective in pulling the interest rate down and reducing the cost of borrowing for both common people and the investors. It can also result in higher investment and higher business and financial activities. But the influence of these effects depends on the financial condition of the economy. If the economy is already economically sound, QE2 can result in higher investment but if the economy is average or not doing very well, QE2 policy is not capable of bringing a positive long-term change in the economy (Thoma, 2011).

When QE3 takes place, the central bank needs to reach some decisions according to varying circumstances of the market. The central bank needs to take a meticulous look at the market scenarios and demands because one wrong decision of the central and printing money when it’s not required, can lead to misleading and confusing circumstances. Sometimes, more money is required in the economy but at some point, printing more money can result in inflation. This rise in inflation has the tendency to lead to an increase in interest rate and capitalization rate (Frydman, 2014).

It is suggested that, QE3 can lead to ‘no saving’ behavior of common people that can also result in deteriorated welfare of the next generation. This effect is specifically significant in economies where saving trends are already not very popular. In most economies, QE3 might lead to more investment in the inward innovation and can also reduce the tendency of outward innovation investment (The Daily Reckoning, 2012).

Identify how QE may impact:

  • Different sectors of the economy (e.g., households, banks, corporations), and

  • Macroeconomic variables (e.g., inflation, bank lending, employment).

While implementing QE in the economy, the aim of the central bank is to divert its focus from the inflation in the economy to the excess reserves of the banks in the economy. Most economists believe that the QE implementation can lead to higher investments in the economy and bring economic growth but sometimes, it also leads to inflationary pressure in the economy (Putnam, 2013). That is the reason why mostly central banks make the investors and the people in the economy believe that the QE policy is not going to effects the inflation rate in the economy and is certainly not going to increase it. It also affects the risk premiums for investors. The central bank uses it as a tool to indicate that it is still focusing on the lower interest rate.

The impacts of QE depend on the sustainability of the imperfect assets in the economy and inflation expectations of the households and investors (Juvenal, 2015). The effects of QE on corporate and their credit risk seem to be disproportionate and can also change according to the varying circumstances (Krishnamurthy & Vissing-Jorgensen, 2011). Sometimes, QE is not focused to keep the inflation and interest rate lower but is the ‘result’ of lower interest rates (Nellis, 2013).

What are the main costs of QE?

QE is expected to cost the Treasury a high price that might also overweigh the benefits of the policy. IMF showed the concern that the banks should give a second thought on their unconventional ‘exit-strategy’. It is also expected that the bond prices start to decline sharply reducing their demands in the market that can lead to lower financial activity (Stewart, 2013).

QE is also reported to be a vicious circle in which the bank does nothing more than just going back and forth in the same direction by raising and dropping the interest rate with having a so-called control over the inflation rate in the economy. This unconventional policy, according to some economist can lead to lower economic activity and can sometimes halt the long-term growth in the economy (Boesler, 2013).

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