ECO610 Discussion 2 Week 4 Monetary Policy and Exchange Rates

Quantitative Easing Tapering

A country’s central bank uses quantitative easing as a tool of monetary policy to affect the economy. For instance, the U.S Federal Reserve buys securities on the open market in order to lower interest rates and expand the money supply. With the additional bank reserves created by quantitative easing, banks have more liquidity, which promotes lending and investment. A reduction in quantitative easing is intended to have an inverse effect where the goal is to drive interests up and cut the level of the money supply. 

How a decrease in quantitative easing will influence the exchange rates.

 A decrease in QE will have a significant impact on the bond market where there will be a decrease in demand for securities, in this case, bonds which decrease their prices. There is an inverse relationship between bond prices and their associated yields. Therefore, decreased QE will lead to a rise in the associated bond yields and a spike in the current interest rates. An increase in interest rates will attract foreign investors due to the low bond prices and their future yields. Therefore, there will be a high demand for the home currency thus leading to an increase in its value relative to other foreign countries' currencies.

Analyze how the changes in the Fed’s policy will influence each of the components of aggregate demand.

Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. The 2014, QE tapering program would have profound impacts on the above components (Malpass, 2014). Government spending will be among the first components that would be directly hit by tapering. Tapering leads to a direct reduction in government spending as the government goes slow on its bond purchases. This means that the government has reduced its overall expenditure. The Fed’s quantitative easing program was geared toward a near-zero interest strategy. There a tapering program would lead to an increase in the current level of interest rates. The sudden spike in interest rates will adversely affect investments as it would be costly to secure investments. Investments become expensive due to the high opportunity cost. It would be more logical to save with banks than borrow money for investments. Tapering will affect consumption by affecting the level of inflation. When there is QE there is an inflationary effect. Pulling money out of the economy, the general price levels will go down which will spark the level of consumption in the short run. The tapering program will also affect the level of net exports due to the foreign exchange effects. Since interest rates will rise, the value of the home currency (dollar). When there is a high value of the dollar, people will be discouraged to pay for exports. This effect leads to fewer exports and increased importation which translates to a decrease in net exports.

References

Malpass, D. (2014, September 1). Monetary policy relief: Finally adding growth. Forbes. https://www.forbes.com/sites/currentevents/2014/04/16/monetary-policy-relief-finally-adding-growth/Links to an external site.