QE + Taylor Rules

Question 1

Describe the idea of QE

Answer 1

• during/ after the GFC MP was not working
• rates couldn’t be reduced further by expansionary MP (liquidity trap)
• So, BoE created £billions of electronic money to buy LT government bonds (gilts)

Question 2

What are the 6 mechanisms with which MP transmission mechanism flows under QE!

Answer 2

1. Policy signalling
2. Portfolio rebalancing
3. Liquidity effect
4. Exchange rate
5. Confidence
6. Bank lending

Question 3

Describe how policy signalling works?

Answer 3

• CB buys large volume of gilts
• simultaneously injecting significant level of reserves into financial system
• signals CB unlikely to tighten MP if QE in place (loosening)

Question 4

Describe how portfolio rebalancing works?

Answer 4

• CB buys large volume of gilts
• increasing price of gilts and lowering yields
• through arbitrage price of other LT assets rises and LT yields falls
• also leads to portfolios held by PS being less volatile as duration risk is lessened due to BOE purchasing gilts
• this feeds into increasing AD and output etc

Question 5

Describe the liquidity effect

Answer 5

• purchase of gilts increases liquidity in the market
• reduced liquidity premia
• more liquid assets - lower transaction costs
• further reduced LT rates

Question 6

Describe the exchange rate effect

Answer 6

• falling yields should lead to depreciation of currency
• should stimulate NX (X-M) increases
• increasing AD and output

Question 7

Describe confidence mechanism

Answer 7

• QE increases confidence in the same way as traditional MP
• confidence can return to financial markets - large scale purchases can lead to improved liquidity and confidence across financial markets

Question 8

Describe bank lending mechanism under QE

Answer 8

• QE increases reserves and bank deposits
• might encourage banking sector to lend (depends on CoMBs having sufficient liquid assets)