Unconventional Tools of Monetary Policy Flashcards
During the Great Recession, how much did US and UK GDP fall and how much was US unemployment?
5%, 7%, and 10%
How long did the US and UK take to recover from the GFC?
2 years and 1.5 years
Why would a central bank set a negative interest rate for commercial banks?
The Bank of England was basically trying to convince the banks not to hold excess amounts of cash (beyond what was necessary) in the central bank and loan it out instead.
What is the conventional tool of monetary policy and why could it not be used during the GFC?
The conventional tool of monetary policy is the policy rate, which influences short-term interest rates. Policy rates were stuck at 0 and could not be lowered further, so unconventional tools became necessary to stimulate the economy
What is the policy rate and how does it differ from the interest rate?
The policy rate is the rate controlled by the central bank, as opposed to the interest rate which is determined by market forces. They are closely intertwined, and the short term interest rate closely follows the policy rate
What were unconventional tools of monetary policy designed to do?
- They were designed to decrease long-term interest rates (i.e. flattening the yield curve), which can affect things like firms borrowing on fixed terms over ten years and fixed rate mortgages
- The hope was to stimulate long-term markets
How does QE work, basically?
QE is the purchase of assets, mostly government bonds, from the private sector, mainly banks, financed by CB money creation. the CB buys the bonds, creating more money reserves for banks in hopes the reserves will be loaned out to stimulate the economy. These reserves count as part of the CB’s liabilities. Any increase in CB liabilities is an increase in the money supply
What is the main transmission mechanism of QE?
decreased long-term bond yields
What is a bond?
A bond is an instrument that the government or a business uses to finance itself. A bond pays the investor a fixed interest payment, called a coupon, every year until the maturity date. On the maturity date, the principal of the bond, or its initial value, is repaid
What is the yield on a bond?
It is the interest rate on a bond –this is coupon + principal all over price. There is an inverse relationship between price and yield
Why is the yield curve upward sloping?
Investors may be expecting the CB to tighten monetary policy and raise the policy rate due to an expanding economy, so they incorporate this info, and yield prices increase. Even if the CB is not planning to tighten monetary policy, the yield curve will naturally slope upwards since longer term bonds carry greater risk, and the higher interest rate compensates for this risk
The liquidity (term) premium
the higher interest rate on long-term bonds to compensate for the higher risk compared to short-term bonds
What is the primary objective of QE?
flatten the yield curve and therefore boost investments
How does purchasing government bonds attempt to stimulate the economy?
Purchasing bonds leads to an increase in the demand for gov. bonds, causing the demand curve to shift right and prices to increase. When prices increase, yields fall, and this means the liquidity premium falls. The government also decreases government borrowing costs and makes it easier to finance a budget deficit in addition to stimulating an economy
What is the main channel through which QE can potentially stimulate the economy?
portfolio rebalancing channel
