Deflation and Quantitative Easing

Deflation and Quantitative Easing

A1.

(a). Threat of deflation

The ECB president’s idea of applying QE within the Eurozone is motivated by the threat of deflation- which is a calamity for a monetary economy.  The persistent falling of prices is affecting ECB’s monetary economy in the following ways:

  • Reinforcing a slump in household spending- Household do not see the importance of buying today when the prices will be lowered in future
  • Companies ease off on their expenditures- They consider to invest in future when prices stabilize
  • Second-round effect of falling prices- when prices fall, also demand fall and companies decide to minimize their expenditures.

(b). Opaque Transmission Mechanism

The transmission mechanism in Eurozone has been more opaque. Inflation rates in the region substantially vary. While prices fall in some countries such as Spain, Greece, and Portugal; prices have been increasing in other countries such as Germany and Netherlands. The president’s idea of applying QE is hammering down longer-interest rates in the region. The purchasing government bonds on a large scale will ECB to undertake QE hence pushing their prices. Since the interest rate on a government bond is inverse to its price, the cost of borrowing would fall. There is nothing else the President can do other than applying QE.

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A2.

Advantages of QE

(a). Lowers interest rates:

Quantitative Easing increases the monetary base in the system of the money supply. Higher money supply results in a reduction in the interest rates. Low interests aid expansionary monetary policy. As a result, the boom phase grows bigger.

(b). Drains toxic assets

The application of QE enables the central bank to purchase assets from the open market using newly created money which is injected into the system.  Purchasing government bonds by the Central bank raises market liquidity hence enhancing assets safety.

Disadvantages of QE

(a). Inflation

QE policy is against the Central Bank’s goal of minimizing inflation. QE creates money and uses the same funds in amplifying lending where these monies are treated as reserves, inherently inflationary.

(b). Kicking the can

QE never resolves any underlying crisis in the economy; it only postpones the problems when they continue to advance in the ground. In the long run, ignoring to fix any economic crisis created by easy credit and excess debt leads to a bigger fall of the Central Bank.

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