1. Based on your reading of the literature, do you believe that monetary policy
ID: 2805682 • Letter: 1
Question
1. Based on your reading of the literature, do you believe that monetary policy should target asset prices explicitly? Give reasons for your answer.
2. (a)
Compare, briefly, the Keynesian theory of money demand with that of Milton Friedman?
(b)
Explain, in as much detail as you can, the design and implementation of the ECB’s Quantitative Easing strategy.
2. (a)
Compare, briefly, the Keynesian theory of money demand with that of Milton Friedman?
(b)
Explain, in as much detail as you can, the design and implementation of the ECB’s Quantitative Easing strategy.
Explanation / Answer
Question 2 (a)
Milton Friedman introduced Monetarist economics as a direct criticism of Keynesian economics theory. The difference between these theories is that Keynesian economics involves government expenditures, while monetarist economics involves the control of money. Keynesian economists believe that a troubled economy continues in a downward spiral unless something is done to drive consumers to buy more goods and services. Monetarists believe in the control of the supply of money in the economy and allow the rest of the market to fix itself. Both of these macroeconomic theories directly impact the way lawmakers create fiscal and monetary policies. If both types of economists were equated to motorists, monetarists would be most concerned with adding gasoline to their tanks, while Keynesians would be most concerned with keeping their motors running.
Keynesian Economics:
Keynesian Economics is similar to demand-side economics. The economists believe the economy is best controlled by manipulating the demand for goods and services, although, these economists do not completely disregard the role the money supply has in the economy and on affecting the gross domestic product. They do, however, believe it takes a great amount of time for the economic market to adjust to any monetary influence. Keynesian economists believe in consumption, government expenditures and net exports to change the state of the economy.
Monetarist Economics:
Monetarists are certain the money supply is what controls the economy. They believe that controlling the supply of money directly influences inflation. Additionally, monetarists believe that by fighting inflation with the supply of money, they can influence interest rates in the future. Imagine adding more money to the current economy and the effects it would have on business expectations and the production of goods. Monetarist economics founder Milton Friedman believed monetary policy was so incredibly crucial to a healthy economy that he publicly blamed the Federal Reserve for causing the Great Depression. He implied it is up to the Federal Reserve to regulate the economy.
Question 2 (b)
The European Central Banks started buying assets from commercial banks in March 2015 as part of its non-standard monetary policy measures. These purchases of assets, also known as quantitative easing or QE, support economic growth across the euro area and help us return to inflation levels below, but close to, 2%.
The European Central Bank has made a number of changes to the original guidelines of its quantitative easing programme. These changes are welcome because the original guidelines would have constrained the programme’s implementation. The changes announced expand the universe of purchasable assets and give some flexibility to the ECB in the execution of its programme. However, this might not be enough to sustain Quantitative Easing throughout 2017, or if the ECB wishes to increase the monthly amount of purchases in order to provide the necessary monetary stimulus to the euro area to bring inflation back to 2 percent. To increase its flexibility, the ECB could further alter the composition of its purchases. The extension of the Quantitative Easing programme also raises some legitimate questions about its potential adverse consequences. However, the benefits of this policy still outweigh its possible negative results for financial stability or for inequality. The fear that the ECB’s credibility will be undermined because of its Quantitative Easing programme also seems to be largely unfounded. On the contrary, the primary risk to the ECB’s credibility is the risk of not reaching its 2 percent inflation target, which could lead to expectations becoming disanchored. EXECUTIVE SUMMARY The European Central Bank (ECB) has made a number of significant changes to the original design of its quantitative easing (QE) programme since the programme started in January 2015. The bank has expanded the list of national agencies whose securities are eligible for the Public Sector Purchase Programme (PSPP); it has changed the issue share limit (ensuring that the Eurosystem will not breach the prohibition on monetary financing), which was originally set at 25 percent, to 33 percent (at least for securities without collective action clauses); it has added regional and local government bonds to the list of eligible assets; it has announced that the programme would continue past September 2016, the previously-announced minimum end-date, to March 2017 “or beyond, if necessary”; and it has declared its intention to reinvest the principal payments on the securities purchased under the programme as they mature. As explained in Claeys et al (2015b), the programme’s original guidelines would have constrained the size and duration of the programme, especially if it was sustained throughout 2017. The changes to the design of the programme announced during 2015 greatly expand the universe of purchasable assets and should therefore delay the point at which limits will be reached. However, the decision to reinvest the principal payments as bonds mature, by increasing the monthly monetary purchase after March 2017, would also lead to the limits being reached sooner. In the same way, a decision by the ECB to increase the amount of PSPP purchases each month, for instance from €44 billion to €64 billion, would also frontload the purchases. In the end, because of the issue share limit, for a given set of securities there will always be a trade-off between larger monthly purchases and a prolonged programme. Further changes to the design of the programme will have to be implemented in order to increase the duration of the programme if the limit is binding in a major country before inflation is on the path towards 2 percent.
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