Thursday 31 July 2014

Chaos in Basel: European Monetary Policy (Pt. I)



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.


Europe:
[i] C. Lagarde (2014), The Global Economy, National Press Club, Washington.

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