There are fundamentally two ways for governments and central banks to influence the economy - through fiscal policy and through monetary policy. Fiscal policy instruments would be things like increasing government expenditure to increase demand in the economy or imposing restrictions on wages to reduce inflationary pressures. These were the instruments favoured by Keynes, and used by most governments in the two to three decades following the war. However, they were unable to deal with a situation of low growth and high inflation in the seventies ('stagflation') and so largely fell out of fashion. Monetarist economists (and their New Classicalist mates) would argue that this is because any increase in government expenditure in the economy 'crowds out' private sector investment. This means that the overall effect on the economy is smaller than the cost of borrowing to finance the extra public expenditure. Keynesian economists might acknowledge crowding out, but would argue that the effect is small. Monetarists would argue that it is large. New classicalists would argue that the crowding out effect is close to 100%.
Monetary policy concentrates on managing the supply of money in the economy - more money, more demand etc. Interest rates are the most common instrument that governments and central banks use. Too much inflation? Raise interest rates. By and large, monetary policy instruments have worked well since the 1980s, although they work best if other instruments are not interfered with - no large budget deficits and no fixed exchange rates. In particular if you fix your country's exchange rate in relation to another currency with different monetary pressures, you can really bugger things up (this is what Nigel Lawson did when he took Sterling into the European Exchange Rate Mechanism in the eighties). Supply side reform is also important - deregulation, reducing trade union power, increasing employment flexibility etc.
So if you have an economy in recession - or in danger of recession because commercial banks' abiliity to lend to businesses is restricted by their own exposure to risky debts - you would generally want to: a) reduce interest rates; b) increase government expenditure (if you take an old-fashioned Keynesian view of the crowding out effect); or c) both.
But what if the government's budget deficit is already so high (and going to get worse because of reduced tax incomes during a recession) that increasing government expenditure isn't possible AND interest rates are already close to zero? That was the situation the government and the Bank of England faced in 2008. Reducing interest rates to negative rates is theoretically possible, but politically unlikely. Can you imagine building societies having to charge people to look after their money for them?
So, quantitative easing becomes one of few available instruments. It's worth pointing out that at least we had that option. Countries that don't have control of their own money supply (Greece for example and in fact all of the Eurozone countries) can't even do this. They're really buggered.
![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
no subject
Date: 2010-07-22 09:49 am (UTC)I'll start at the beginning.
There are fundamentally two ways for governments and central banks to influence the economy - through fiscal policy and through monetary policy. Fiscal policy instruments would be things like increasing government expenditure to increase demand in the economy or imposing restrictions on wages to reduce inflationary pressures. These were the instruments favoured by Keynes, and used by most governments in the two to three decades following the war. However, they were unable to deal with a situation of low growth and high inflation in the seventies ('stagflation') and so largely fell out of fashion. Monetarist economists (and their New Classicalist mates) would argue that this is because any increase in government expenditure in the economy 'crowds out' private sector investment. This means that the overall effect on the economy is smaller than the cost of borrowing to finance the extra public expenditure. Keynesian economists might acknowledge crowding out, but would argue that the effect is small. Monetarists would argue that it is large. New classicalists would argue that the crowding out effect is close to 100%.
Monetary policy concentrates on managing the supply of money in the economy - more money, more demand etc. Interest rates are the most common instrument that governments and central banks use. Too much inflation? Raise interest rates. By and large, monetary policy instruments have worked well since the 1980s, although they work best if other instruments are not interfered with - no large budget deficits and no fixed exchange rates. In particular if you fix your country's exchange rate in relation to another currency with different monetary pressures, you can really bugger things up (this is what Nigel Lawson did when he took Sterling into the European Exchange Rate Mechanism in the eighties). Supply side reform is also important - deregulation, reducing trade union power, increasing employment flexibility etc.
So if you have an economy in recession - or in danger of recession because commercial banks' abiliity to lend to businesses is restricted by their own exposure to risky debts - you would generally want to:
a) reduce interest rates;
b) increase government expenditure (if you take an old-fashioned Keynesian view of the crowding out effect); or
c) both.
But what if the government's budget deficit is already so high (and going to get worse because of reduced tax incomes during a recession) that increasing government expenditure isn't possible AND interest rates are already close to zero? That was the situation the government and the Bank of England faced in 2008. Reducing interest rates to negative rates is theoretically possible, but politically unlikely. Can you imagine building societies having to charge people to look after their money for them?
So, quantitative easing becomes one of few available instruments. It's worth pointing out that at least we had that option. Countries that don't have control of their own money supply (Greece for example and in fact all of the Eurozone countries) can't even do this. They're really buggered.