Over
the past months, Europe has faced a number of broad ranging problems from
fighting the pull of the ‘ogre’[i] that is deflation, to the
juggling act between the needs of the driving economies, and the less developed
ones, which has become more pertinent than ever before in this delicate
recovery period. There are a number of differing views on how to solve the
problems faced by central banks around Europe, and there are disputes about
this at all levels of society from individuals to huge institutions such as the
Bank of International Settlements (BIS) and the Organisation for Economic
Co-operation and Development (OECD).
There
are, in this debate two main schools of thought: expansionary and
contractionary. Expansionary monetary policy aims to increase Aggregate Demand
(AD) and induce demand-pull inflation. These changes are affected through a
number of processes, the first of which is the most commonly discussed- base
rates. If base rates are reduced, the amount that households have to pay on
variable-rate mortgages and other simple necessities falls, raising Real
Disposable Incomes (RDIs), and thus consumption (C). The base rate reduction
would be able to increase levels of investment (I) as firms can borrow more
cheaply and also use their increased levels of retained profits that would be
gained from reduced amortization rates. To supplement this increase in the
velocity of money in the economy, further expansionary policies would include Quantitative
Easing (QE) (or Open Market Operations (OMO) as it is referred to in the
Americas). QE is a method by which the Central Bank can expand the Money Supply
(MS) for their currency through asset purchases (i.e. bonds) which injects
money into commercial lenders providing more liquidity and thus reducing
lending costs, encouraging growth. This could even develop into operations akin
to the ‘Helicopter Drop’ wherein the ‘middle-men’ (high street banks) are
completely avoided and the population are simply given money to spend, inducing
further demand-pull inflation. In the long-run, there are other, additional
effects of cheaper borrowing and increased liquidity in the market- the most
prominent of which is the expansion of the potential output of the economy
(i.e. Aggregate Supply (AS)). The expansion in AS could be caused by the
falling price of investment as a result of the aforementioned processes, which
translates as a reduction in the cost of factors of production.
There
are also numerous effects on exchange rates and net-exports that can be traced
back to changes in monetary policy; an expansion in the money supply will
increase the value of the Euro (EUR) in its bilateral exchanges with major
financial partners due to the high relative inflation. In ‘normal’ cases, where
the Marshall-Lerner condition applies, this could lead to a deterioration of
the current account and thus causing ‘demand-pull disinflation’,
counterbalancing the effects of the initial inflation. In other cases, however,
the Marshall-Lerner condition does not apply as in the UK where over 40% of
food is imported, and the financial services and chemical products exported are
of such high quality and so ingrained in foreign production processes that both
exports and imports have very inelastic Price Elasticity’s of Demand (PEDs).
Here, what is essentially a price increase for imports, and a reduction for
exports, will lead to the current account position improving quite
considerably, leading to an expansion of AD and demand-pull inflation. For the
EU, fortunately, the net-exports are not as large a part of the economy as they
are for the UK meaning that the inflation rate will be somewhat rebalanced,
without large negative implications for the employment and national income (Y)
when expansionary monetary policy is introduced.
No comments:
Post a Comment