Macroeconomics and Financial Crisis

Open Market Operations

Open market operations (OMO) are the principal tool of monetary policy. There are two possible goals for OMOs, affecting the federal funds rate or the depository reserves of depository institutions at the Central bank. OMO is achieved through purchase and sale of treasury bills, therefore expanding or contracting the monetary base. By engaging in OMO, the depository institutions with excess end-of-day balances can lend the extra money to other institutions through the federal funds markets at the now lowered federal funds rate thereby stimulating the economy.

Helicopter drop of Money

Regarding the helicopter drop, Milton Friedman famously said: Let us suppose now that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky Let us suppose further that everyone is convinced that this is a unique event which will never be repeated, (Friedman [1969, pp 4-5]) A helicopter drop is typically undertaken by the Federal Reserve and the Treasury. There are two basic methods of achieving this; the Fed can directly buy Treasury bills from the government. The government can then spend this money to stimulate the economy. This is basically a combination of a fiscal transfer and OMO. The other way is the way that Friedman suggests; somehow give the money to the people for example by sending a $1000 dollar cheque to every household in America. Such action through the use of treasury bills leads to a substantial increase in the governmental debt. The goal is to induce the belief in future inflation thereby promote spending today. The belief of future inflation comes because of the increased

monetary base but also because the Federal Reserve has a vested interest in reducing the governments debt burden. It would do this by inflating its way out of debt.

Quantitative Easing (QE) Bank of England (BoE)

The BoE engages in quantitative easing in order to increase consumer spending and meet its target inflation rate of 2%. When faced with a potentially deflationary environment or with lower bound with respect to short-term interest rates, central banks are required to engage in creative banking. The BoE engages in QE by purchasing financial assets, primarily government bonds, from private entities such as banks, insurance companies and even non-financial institutions. To a lesser extent, the BoE also purchases corporate bonds in order to inject money directly into the market. By injecting money into the financial system, the BoE intends to increase assets prices and thereby reducing the yields. This results in a decrease in the cost of borrowing for households and businesses inducing more spending and therefore achieving its goal of inflation.

Quantitative Easing (QE) Federal Reserve (Fed)

The goals of QE for both the BoE and the Fed are in principal the same; however the method was slightly different for the Fed. The Fed was much more aggressive in its QE. At the first sign of contagion, the Fed introduced a stimulus package which included purchase of treasury securities, toxic debt issued by companies such as Freddie Mac and Mortgage-Backed-Securities. By doing so it prevented a collapse of the entire banking system however it has so far not resulted in economic recovery.

Operation Twist
Operation Twist refers to the attempts by the Fed to twist the long term yield curve on Treasury bonds. It did so by purchasing $400bn of long-term treasury bonds in 2011 to put downwards pressure on long-term interest rates. The Fed already has a balance sheet with over $1tn in medium-term and long-term bonds. In September 2011, when it decided to engage in Operation Twist, it did so by selling medium-term bonds in exchange for long-term bonds. By doing so it avoided expanding its own balance sheet even further. The result of this purchase was quite miniscule as it resulted in the interest rate of 10-year bonds falling from 3.22% to 3%.1

Long Term Refinancing Operations

This is the European Central Banks (ECB) answer to the Quantitative Easing in the United States. Instead of directly purchasing troubled assets like BoE or the Fed, the ECB has instead offered up to 3 year cash loans which accept troubled financial assets such as sovereign bonds as collateral. The LTRO is supposed to have a twofold action of increasing liquidity and therefore lending and economic recovery as well as reducing the spread on the bonds countries such as Italy and Spain. The first example of the LTRO was on 21 December 2011 when the ECB offered 489 at 1% interest rate over 3 years.

Relationship between the different Central bank strategies

In order to understand the relationship between the different operations, it is perhaps important to understand the reasons why the Central banks engage in these actions.

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OMO is the typical tool of most central banks during normal times and is generally used to tweak the short-term interest rate. The OMO typically works in conjunction with the other tools that Central banks tend to use under normal times such as reserve requirements and short-term or long-term interest rates. All the other measures are basically creative alternatives to the OMO in response to long-term financial crisis. Often the tool that the central bank chooses to employ is directly in conjunction with its mandate. For example, BoE is mandated to maintain inflation at 2% and once it had exhausted other options to stimulate the economy it resorted to conservative QE. Depending upon the start level for the interest rates, a central bank has room to manoeuvre as a response to a crisis. However, in the latest crisis interest rates were already at historical lows, which meant that central bankers were in essence caught in a liquidity trap. The 0% boundary limit for the central banks means that they typically have to look at other ways to coax people and companies into increasing spending. Under conditions of deflationary expectations people often consider money to be the safest asset and hence hold on to even larger amounts resulting in reduced spending. This behaviour is exacerbated when companies engage in such hoarding as well because they do so at the expense of profitable projects and therefore influence the overall employment rate as well. The main goal of most central banks during a recession or a crisis is to stimulate recovery. In order to do it looks to expand the monetary base thereby increasing the belief in future inflation and hence inducing higher consumption today. The only proved tool so far is OMO however it only works under normal situation, the effectiveness of the other tools is still questionable.

Pick two of the above policy initiatives that have different monetary transmission mechanisms. Explain how the effects of these two initiatives may vary over time as they are implemented.
When the Fed engages in expansionary monetary policy through the use of OMO, it typically purchases short term treasury bills on the open market. The direct result of this is to increase the monetary base by either providing liquidity to the treasury (if the bills are bought directly from the treasury) or to the overall economy. The Fed pursues OMO when the economy shows signs of stagnation to drive to short-term interest rates and increase expectations of inflation. This results in increased consumer spending and therefore a revival in the economy. The converse is true when the Fed engages in contractionary monetary policy. Since OMOs only affect the short-term interest rate and not the long-term interest rate it gives the Fed some room to manoeuvre regarding its long-term plans. Hence the only long-term effect of OMOs is to stimulate the economy in the direction of potentially higher interest rates in the future. When faced with recession and 0% interest rates the Fed is no longer able to engage in OMO. In such a scenario in order to stimulate the economy it can resort to unconventional monetary policy such as QE. QE involves the purchases of financial assets from across the economy including financial and non-financial institutions. The first round of QE was intended to shore up the US banking system in 2008 when faced with the credit crunch. However, the intended effect is expected to be similar to that of OMO, to increase the monetary base, inflation, consumer spending and economic revival.

Based on the evidence so far QE has so far achieved its first goal of shoring up the economy, however it is very questionable whether it has had any positive effects on the economy. According to Bernanke, the goal of QE2 was for the Fed to act as the investor of last resort and raise asset prices such that investors would spend their new found wealth. The long-term effects of QE are uncertain because QE is typically used in times of crisis and the only country to have implemented QE in the long-term has been Japan and the results from that experiment would indicate that QE has no long-term impact. However, I feel that QE cannot be effective unless there is a marriage between fiscal policy, monetary policy and regulation. The authorities need to address the fundamental problem which caused the crisis. As in Japan, the reluctance on the part of the banks to write-off non-performing loans was the main reason for the stagnation. The government was very worried about taking the tough decision to force the banks to write off the debts because that could have resulted in massive unemployment. As a result, new and enterprising businesses find it difficult to acquire loans and the economy continues to stagnate. The same fears regarding the banking system in the US

Does the absence of high inflation in the USA, Japan, and the Eurozone at the moment refute the Quantity Theory of Money?
According to the Quantity Theory of Money (QTM), there is a direct connection between the amount of money in the market and the price level of good and services and therefore inflation. It treats money like any other commodity in the sense that as the amount of money increases its marginal value decreases in relation to the value of other commodities in the market. According to the Fisher Equation where: MV = PT M = Money Supply V= Velocity of Circulation P = Average Price Level T = Volume of Transactions of Goods and Services If the velocity of money is assumed to remain at a constant level, as the supply of money increases then either P or T need to increase in the corresponding proportion. However if the economy is already at capacity in terms of real output i.e. goods and services then the only possible outcome is an increase in the price level because an ever increasing amount of money will be used to buy a constant amount of goods and services. So if we assume the truth regarding the QTM then the present economic situation in the Eurozone, US and Japan is quite surprising because of the absence of high inflation. The central banks of these countries, in particular Japan and the US, have undertaken expansionary monetary policies for a number of years which would

suggest that these countries should be facing inflation and therefore the central banks would then pursue contractionary policies. This would lead to us to question the assumption regarding the constant velocity of money. According to the definition, the velocity of money is defined as the number of times a given amount of money changes hands during a specified time period. However, in deflationary or recessionary periods when the future value of $1 is assumed to be higher people prefer to hang on to the money rather than to spend it today resulting in a reduction in the velocity of money. Additionally, in these

countries the recessions took place primarily due to the collapse of the respective financial systems. The only way for the central bank to inject money into the real economy is through the banks and if the banking system is facing a structural failure then the entire system falls apart. This is evident in Japan which has experienced multiple rounds of QE but no corresponding increase in inflation because the banks accept the money from the Bank of Japan (BoJ) but just add it to their balance sheets and do not pump it into the real economy in the form of new loans to businesses and individuals. In conclusion, I would state that the QTM, though a useful theory, is a very simplified theory because it does not anticipate the counter intuitive actions of the different participants in an economy.

Explain why the Bundesbank appears to be upset with the European Central Banks LTRO?
As mentioned above, the LTRO is the ECB response to QE by injecting money directly into the financial system. At the time the LTRO was introduced the Eurozone was in serious danger of facing an imminent collapse as banks balance sheets were loaded with toxic sovereign bonds. In addition the new capital requirements under the Basel III agreement meant that banks were required to sell their assets at below market rates. Hence this cheap money helped shore up the banking system. It would have been wholly irresponsible if the ECB had not acted because being the central bank it should take its role as the lender of last resort seriously. The Bundesbank is unhappy with this policy because it is completely contrary to Eurozones ban on central bank funding of governments. It believes that banks will continue to invest in sovereign bonds driving up prices and consequently driving down yields, thereby funding the fiscal policies of heavily indebted governments. It views the problems faced by the Eurozone economies as primarily the result of poor fiscal policy and hence throwing more money at the problem is unlikely to fix the issues. It believes that by rewarding these countries for poor fiscal policies it is in effect just delaying the problem because the problems faced by these countries are really fundamental problems. For example, Greece currently has a bloated public service sector in combination with rife tax evasion and this infusion of money is just preventing much needed reform. Additionally, LTRO raises the question of moral hazard. It allows banks to borrow at record low levels in order to invest in much riskier investment opportunities. In effect

it transfers the risk to the ECB because the banks realise that they will always be covered regardless of their investment decisions. The next question would be whether the ECB is just delaying the present crisis for a much larger crisis in the future, when these loans come due. In this present economic condition, banks are unable to make loans to companies or individuals because of the negative outlook and hence are required to take on riskier investments in order to repay these loans in the future. The Bundesbank is also worried by the poor growth prospect in many of the countries and hence the repayment abilities of the banks.