Assess the consequences of quantitative easing and low interest rates on an economy and its trade partners.

In 2009, the Bank of England engaged in what is known as ‘quantitative easing’ by pumping more than £200 billion into the economy. Record low levels of interest rates have also been maintained within the U.K. economy.

Quantitative easing and low interest rates have also been adopted by the U.S. 

Assess the consequences of quantitative easing and low interest rates on an economy and its trade partners. [25]

Introduction

Lowering interest rates is a form of expansionary monetary policy. 

(RWA) Quantitative easing, in the context of the U.S., is a modified form of expansionary monetary policy that involves a more aggressive stance on asset purchase on the part of the government, which aims to release liquidity into the economy.

LIKELY IMPACT ON AN ECONOMY

01 Increased consumption

·      The effect of low interest rates will bring about increased consumer spending. Consumers are more willing to buy large ticket items as they would rather spend than save when interest rates are low, since the opportunity cost of spending is low. This will increase consumption. An increase in consumption will increase aggregate demand, bringing about a multiplied increase in national income and therefore economic growth will increase. Firms will hire more factor inputs such as labour to produce the higher level of output, therefore reducing unemployment. (Figure 26) 

Figure 26. Effects of lower interest rates

The problem with low interest rates is that they tend not to be very useful when the economic outlook is poor (which is usually the case why interest rates are cut in the first place), since consumption and investments will not be very responsive to interest rate changes.

02 Increased investments

·      Low interest rates should also encourage investment spending since there is a higher rate of return when interest rates fall, which will increase the volume of investments (based on the MEI curve).

·       EV. However, when interest rates are already very low, quantitative easing may be used.

·       (RWA) Quantitative easing is used by central banks when interest rates are already zero or close to zero. The central bank will then proceed to expand its asset purchase exercises to include corporate bonds, longer-term government bonds in order to reduce long-term interest rates and to stimulate spending in specific sectors. Investments will likely increase when long-term interest rates fall, and when liquidity is made available in previously trapped sectors through government asset purchases. The increase in investment will increase aggregate demand, bringing about a multiplied increase in national income and therefore economic growth will increase. Firms will hire more factor inputs to produce the higher level of output and therefore reduce unemployment. Since spending on capital goods will also increase the productive capacity, the aggregate supply will also increase, leading to an increase in potential growth.

03 Hot money outflow

·      As interest rates fall, there will be hot money outflow, as funds seeking higher interest rates will flow outwards to countries with higher interest rates. This will lead to an increase in supply of the domestic currency on the foreign exchange market, causing a depreciation of the exchange rate.

·      A depreciation of the exchange rate will make exports cheaper and imports more expensive. Demand for exports will increase and demand for imports will fall. Subject to Marshall-Lerner condition, a depreciation should bring about an improvement in the balance of trade and therefore improve the BOP. An increase in (X – M) will also increase aggregate demand, bringing about a multiplied increase in national income and therefore economic growth will increase (same as Figure 26). Firms will hire more factor inputs to produce the higher level of output, thereby reducing unemployment.

02 Hot money inflows

·       The low interest rates may cause hot money outflows from the economy towards the trading partners whom may have higher interest rates. Trading partners who may have higher relative interest rates may experience hot money inflows. 

·       An increase in demand for their currencies will thus lead to an appreciation of the exchange rate of trading partners.

LIKELY IMPACT ON TRADING PARTNERS

01 Increased consumption of imported goods and services from trading partners

·      The aggregated effect of the impacts points towards both an increase in real national income and an increase in employment. This will result in the increased ability by citizens of the economy to consume goods and services. The increased consumption of goods and services will include imports from trading partners.

·      Trading partners will also see an increase in demand for their exports. For trading partners, an increase in (X – M) will also increase aggregate demand, bringing about a multiplied increase in national income and therefore economic growth will increase. Firms will hire more factor inputs to produce the higher level of output, thereby reducing unemployment.

Conclusion

Quantitative easing has been increasingly adopted by major economies like the U.S and Japan, and in the case of U.S, has seen much success. In the long run, such policies would have to be carefully re-modelled to prevent excessive liquidity in the economy to ensure the sustainability of the economy.