During the financial crisis experienced recently, central banks all over the world assumed unconventional monetary measures to counter the crisis. In part, this was because several central governments lacked the ability to pursue the fiscal policy. The current essay looks at the unconventional monetary policies including their implementation through Quantitative Easing and the implications of such measures. Furthermore, the IS-LM and AS-AD models will explain the monetary policies’ roles in the financial crises.
The unconventional monetary policies refer to a set of tools comprising a wide range of measures designed to ease financing conditions. Employing several measures enables monetary policy-makers to have well defined intermediate goals of the existing unconventional policies. According to Mendoza, such measures range from offering additional central bank liquidity to local banks to openly pointing to credit spreads and liquidity shortages in particular market segments. In such a case, the policy-makers will select measures, which best suit these aims. Nevertheless, caution has to be taken due to possible negative outcomes of unconventional measures, especially on the impacts of the financial safety of the central banks’ balance sheet in alleviating the possibility of a return to normalcy in market functioning. Generally, unconventional measures are defined as policies, which directly target the availability of external finance and costs to households, non-financial companies, and banks. Such finance sources can be in the form of equity, loans, central bank liquidity, and fixed-income securities. Given that external finance costs are generally at a premium during a short-term interbank level under which monetary policy is leveraged, unconventional measures are considered as attempts to minimize the spread between different external finance forms, and thereby upsetting the flow of funds and asset prices in the economy. Additionally, given that these measures intend to affect financial conditions, their strategy has to consider the economy’s financial structure, and in particular the framework of the funds’ movement.
One means of affecting the credit costs is by influencing the main long-term rates of interests by affecting the market expectations. For example, the central bank can reduce the real interest rates if it can prompt the public to anticipate higher levels of charges in the future. If anticipated inflation rises, the real interest rates drop, even if the nominal rates remain unchanged at the lesser bound. On the other hand, policy-makers can openly influence the expectations of the prospects in interest rates by opting for conditional commitments to uphold policy rates at the lesser bound for a substantial amount of time. Because rates in the long-term are prima facie averages of anticipated short-term rates, the channel of expectations would likely flatten the whole yield curve once policy-makers obligated to remain at the lower bound. Additionally, a conditional assurance to maintain the same short-term rate lowers for long enough should prevent expectations of inflation from falling, which would alternatively raise the real interest rates and restrain spending. In both cases, if the management of prospects is successful, it will minimize the real rates in the long term and hence result in aggregate demand and borrowing.
Quantitative easing is a method of implementing unconventional policy measures. A decision by the central bank to expand its balance sheet’s size will compel it to select the assistance it opts to obtain. Theoretically, it could obtain any assets from anywhere. However, in practice, quantitative easing has customarily dedicated to purchasing long-term state bonds from commercial banks. Such an idea is dual: first, sovereignty earnings act as benchmarks for valuing riskier confidentially delivered securities. When long-term state bonds are bought, the yields on confidentially supplied securities are anticipated to fall in parallel with those on state bonds. Additionally, if interest rates are in the long-term fall, it will arise investments in the long term and consequently aggregate demand, and in so doing support price stability. In such a case, banks have a crucial role to ensure the success of any quantitative easing measure. If the goal were to foster the provision of new loans to the private sector, central banks would mainly buy bonds from these banks. The extra liquidity would thereafter be used by the banks to spread new credit. Nevertheless, banks may opt to withhold the liquidity obtained at the central bank in exchange for bonds within their financial reserves as a buffer. Here, the liquidity offered by the central bank rests within the financial segment and never flows out of it. This hazard can be reduced if the central bank carries out this kind of operation at the lower bound only i.e. when it has completely exploited the typical interest rate passage. At the lower bound, the compensation of deposits is null or nearly null and there is a minimal or no incentive at all for banks to park extra reserves with the main bank. Employing a quantitative easing policy at a policy rate dissimilar from the subordinate bound may require expansion of the balance sheet of the central bank and therefore increase exposure to risks of the monetary authority. In light of these considerations, the safety of the system of finances is crucial in enabling the success of quantitative easing. Once banks halt advancing loans, this policy ceases to operate. Quantitative easing is fruitful if it tapers the spreads in the market between the rates rewarded on designated credit tools and policy rates, and in the process restraining the dangers of a liquidity deficit and boosting banks to spread credit to advanced interest-paying groups.
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The success of Monetary Policies
During the global financial crisis, most central banks in developed economies deploy unconventional monetary policy measures to enable them to counter financial and economic risks. As rates on policy approached and eventually stagnated at their respective lower bounds, the balance sheets of central banks substituted interest rates as the major policy instrument. The result of this was that the models, which were estimated in the pre-crisis stage with short-term interest rates as the monetary policy instrument became unsuitable for affecting the efficiency of monetary policies in the aftermath of the financial crisis. The challenge remains in finding a suitable econometric means for analyzing the macroeconomic effects of central banks. In particular, the financial crisis had been a significant common factor in the cycles of businesses. The unconventional monetary policies changed dynamics in the financial market of several advanced economies. Thus, the expanded unconventional monetary policy led to significant but provisional increases in output prices in different financial systems.
Roles of the IS-LM and AS-AD Models in the Financial Crises
The financial crisis experienced can be explained using the IS-LM and AS-AD models. The AS/AD model is suitable in ”normal” times during which there exists a well-established monetary policy which rules the operation. In abnormal situations, for instance during deflation, or when the nominal interest rates on zero lower bound are binding, or when the elementary canons of good monetary policy have been ignored, the IS/MP model is superior. Monetary increases usually result into a change in the AD curve and rise yield in the short-term but have no influence on productivity in the medium-run due to the upward shift in the AS curve until output stretches to its natural level. Changes in the monetary policies will definitely change the aggregate demand for productivity and this will consequently result in a shift in the AD curve. On the other end, a financial crisis has implications on monetary policies. Given that financial institutions and markets offer channels for providing funds from savers to borrowers in different sectors of the economy, the LM-IS model provides a framework for the “circular flow of income” within the economy. Thus, it is rational to expect that the effects of the financial crisis do not only affect the economy via the money market, commodity market, but also the LM-IS curve. Fundamental attributes of financial crises have significant effects on private spending and this leads to a steeper shift in the IS curve to the leftward side. The IS curve is also affected in such a financial crisis. Combined, such effects have significant policy implications. Whereas any open monetary policy will turn the LM curve towards the right side by raising the money supply or minimizing the rate of the national reserves, the zero lower bound of the rates of the state funds will impede the economy from advancing towards positions that necessitate negative nominal rates of federal funds.
In conclusion, unconventional monetary policies are designed to ease financing conditions in the form of equity, loans, central bank liquidity, and fixed-income securities of central banks in the wake of financial crises. Quantitative easing assists in implementing the unconventional policy measures in order to alter dynamics in the financial markets. The IS-LM and AS-AD models are important models in explaining financial crises.
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