Week 7 Deck

Question 1

Explain liquidity provision at the BoE and the fed in terms of during covid and the GFC

Answer 1

BoE

• Increased standing facilities than ‘normal times’
• In response to the covid-19 crisis, BoE introduced new lending programmes

    - Covid corporate financing facility (CCFF)
    - BoE buys short-term debt from large companies to allow them finance their short-term liabilities
    - Support corporate finance markets and ease the supply of credit to all firms

• During the 2008 global financial crisis (GFC)

- Introduced discount window facility
    - Banks can borrow up to 30 days - ie. Short term liquidity support

Fed

• During the covid 19 crisis, Fed set up a number of liquidity facilities to financial markets:
○ Pay check protection program liquidity facility
○ To help small businesses
• Main street lending program (MSLP)
○ A set of five facilities
○ Support lending to both small and mid sized businesses and non-profit organisations
• Team asset-backed securities loan facility
○ Set in March 2020 to support flow of credit to consumers and businesses
○ Enables insurance of asset backed securities (ABS) backed by student loans etc
• Discount window expansion
○ Primary credit rate lowered by 150 basis points to 0.25 percent
○ Borrowing terms extended for up to 90 days

• During the 2008 GFC, the Fed implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets
- Discount window expansion
- Fed lowered discount rate to 50 basis points above funds rate
- Term auction facility
- Loans made at a rate determined through competitive auctions
- New lending programs
Providing funds to assist J.P Morgan purchase Bear Stearns

Question 2

Explain the differences between Large-Scale asset Purchase, the objectives and QE and its objectives

Answer 2

• CB purchases of longer-term financial assets
○ Government long term bonds (QE)
○ Corporate bonds
• Objective is to reduce financial frictions and reduce long term interest rates

• CB’s large scale asset purchases (LSAP):

- Gives financial markets confidence
- Injects money into the economy
- Influences bank lending and spending in the economy
    - Can help CB's meet their  monetary objectives

Question 3

Explain large scale asset purchases at the BoE during covid and the objectives (2)

Answer 3

• BoE LSAP programme include: gilt purchases, corporate bond purchases, Term Funding Scheme (TFS)

• At the onset of the covid-19 crisis:
- Launched a new term funding scheme with additional incentives for SME lending (TFSME)
- Asset purchases of £200 billions of gilt and corporate bonds
- Carried out at a record pace of £13.5 billion per week as shown by figure 2
• In June 2020, a further £100 billion of gilts purchases was done by the bank

• Objective of the asset purchases is to:

- lower long term interest rates, consequently stimulating the economy
- Counteract any tightening of the monetary and financial conditions that may result from the gilt market decisions

Question 4

Explain the BoEs LSAP programme during the GFC

Answer 4

• During the 2007-2009 global financial crisis (GFC)
○ BoE adopted QE in March 2009
○ During the crisis the BoE had a ‘bank rescue package’ that totalled £500cbillion for entire banking system
○ Of that, £200 billion was made available by banks through special liquidity scheme
○ As of February 2017:
- Gilt purchases amounted to £445 billion
- Corporate bond purchases stood at £7.7 billion
- £42.9 billions had been drawn in the TF

Question 5

Explain LSAP at the Fed during the covid-19 crisis

Answer 5

• During the covid-19 crisis the Fed:
○ Purchased U.S Treasury securities worth approximately $1.7 trillion between mid-march and the end of June 2020
○ Increased its purchases of mortgage-backed securities as displayed in figure 6
○ Since June 2020, Fed continued carrying out LSAP

Question 6

Explain the three new asset purchase programs introduced to lower interest rates for particular types of credit

Answer 6

1. QE1
   - Government sponsored entities purchase program which purchased $1.2 trillion mortgages backed securities (2008)
   - Large scale purchases of US Treasury securities
   - Asset purchases under QE1 totalled about $1.725 trillion
2. Quantitative easing (QE) 2 - purchased $600 billion long term treasury securities ($75 billion per month) aimed at lowering long term interest rates (2010)

QE3 - $40 billion mortgage-backed plus $45 billion long term treasuries (2012)

Question 7

Explain the ECB responce to covid 19 and GFC

Answer 7

• In response to the covid-19 crisis:

- Launched the pandemic emergency purchase programme (PEPP)
- Temporary asset purchase programme of private and public sector securities
- Purchases of a total of 1,350 billion euros up to end of June 2021

• During the 2007 - 2009 GFC and Eurozone crisis:

- ECB faced political and legal opposition to asset purchases
    - First large QE program occurred In January 2015

Question 8

Quantitative easing versus credit easing

Answer 8

• During the 2008 GFC and covid-19 crisis, CBs became very creative in assembling a host of new lending facilities to help restore liquidity to different parts of the financial system

• This resulted in the expansion of the CBs balance sheet as show by Figure 7: quantitative easing
	- Lending to a huge increase in the monetary base

• Could make potential argument for credit easing Altering the composition of CB balance sheet in order to improve functioning of segments of credit market

Question 9

Explain forward guidance

Answer 9

• This involved communication from monetary policymakers about their economic outlooks and policy plans (‘open mouth operations’)
• Objective is to manage financial markets expectations of future short term interest rates
• Two types of commitment to future policy actions:

    - Conditional
            - Unconditional

Question 10

Explain BoEs forward guidance

Answer 10

• BoE launched forward guidance in 2013: conditional on future developments

• In august 2020 a new forward guidance
	- Provided commitment not to tighten MP until is appropriately
	- The economy is on the way to recovery Reinforces current market expectations of a low bank rate for some time

Question 11

Explain the Feds forward guidance

Answer 11

• By committing to the future policy action of keeping the federal funds rate at zero for an extended period:

	- The Fed could lower the market's expectations of the future short-term interest rates
	- Thereby causing the long-term interest rate to fall

Currently, the Fed intends to keep the Fed funds rate low for quite some time

Question 12

Explain negative interest rates on bank deposits in terms of the Fed and BoE and ECB

Answer 12

• Commercial bank pays CBs to keep their money with them:
• Setting negative interest rates on bank’s deposits:
  • Meant to stimulate the economy by encouraging banks to lend out the deposits they are keeping at the CB
  • Thereby encouraging households and businesses to spend more

• However, there are doubts on the intended expansionary effect of negative interest rates on deposits

Fed

• Not adopting negative interest rates on bank's deposits

BoE

• Not adopting negative interest rates on bank's deposits in Less effective as MP tool to stimulate the economy

ECB

• Interest rates on bank deposits (deposit facility rate) has been negative since 2014
• Effect of ECB’s negative interest rate policy (NIRP) remains controversial
• The bankk in its speech of going negative: the ECB’s experience argues that NIRP has been effective in:
• in turning the Z;B into an effective lower bound well below zero
  in supporting bank lending
  stimulating the economy and raising inflation

Question 13

Why is it important to study monetary policy at the zero lower bound?

Answer 13

• In normal times, CBs can attempt to reduce the real interest rate by lowering the policy rate
  
  • But the policy rate, is stated in nominal terms, and therefore cannot fall below zero
  • The zero floor on the policy rate is referred to as the zero lower bound (ZLB)

At the ZLB it is important to understand how nonconventional policies can be effective in stabilising the economy

Question 14

Explain the relevant demand curves (3)

Answer 14

• The MP curve
  ○ Shows the relationship between the real interest rate set by the central bank and inflation rate
• IS curve
  ○ Shows the relationship between aggregate output and the real interest rate when the goods market in equilibrium
• Aggregate demand curve (AD)
  ○ Shows the relationship between the inflation rate and the quantity of aggregate output when the goods market is in equilibrium
• The AD curve is derived from the MP from the MP and IS curves

Question 15

What is the Taylor Principle?

Answer 15

CBs seek to keep inflation stable

To stabilise inflation, central banks, must raise nominal interest rates by more than any rise in expected inflation, so that the real interest rate r rises when π rises

If a central bank allows r to fall when π rises, then aggregate demand (AD) increases (Yad = AD) when π continues to rises:

Question 16

What happens when the CB hits the ZLB?

Answer 16

With the federal funds rate at the floor of zero
○ CB cannot lower the real interest rate any further
○ Occurred after the Lehman brothers bankruptcy in late 2008 and during the covid-19 crisis
○ As inflation and expected inflation fall, the real interest rate rises, creating a downward slope for the MP curve

• This implies that monetary policy has become ineffective

Question 17

Draw the zero lower bound diagrams

Answer 17

see notes

Question 18

Which curves are relevant for monetary policy at the zero lower bound?

Answer 18

• The relevant curves are:
○ Long run aggregate supply curve (LRAS):
- Shows where the economy settles in the long run for any given inflation rate
- Output equals potential output or the natural rate of output, Yp

○ Short run aggregate supply curve (AS):
Shows the relationship between the quantity of output supplied and the inflation rate:

Question 19

Explain the disappearance of the self correcting mechanism at the zero lower bound

Answer 19

• When the economy is in a situation in which:

	- Equilibrium output is below potential output
	- The ZLB on the policy rate has been reached

• Output is not restored to its potential level if policy makers do nothing

• In this situation, the economy goes into a deflationary spiral, characterised by:
	- Continually falling inflation and output Shown by figure 11

Question 20

Three forms of non conventional monetary policy that a CB ust turn to with the ZLB problem

Answer 20

1. Liquidity provision
2. Asset purchases and quantitative easing
3. Management of expectations (forward guidance)

Question 21

How do the 3 non conventional MP measures help raise aggregate output and inflation in terms of the investment function of AD

Answer 21

1. Lowering f (dash ontop) (financial frictions) in the AD/AS model
2. Consequently reducing the real interest rate for investments
3. Economy returning to equilibrium

Question 22

What effect does lowerinf financial frictions have on monetary policy (AD/AS)

Answer 22

1. nonconventional monetary policy lowers financial frictions and shifts AD to the right
2. Increasing output and inflation

Question 23

Explain Liquidity provision at the ZLB

Answer 23

• At the ZLB credit market seize up and there is a shortage of liquidity
• Shortage of liquidity results in the rise in financial frictions
• Economy moves to point 1 as shown by figure 12
• A CB can lower f (dash on top) directly by increasing its lending facilities
• This provides more liquidity to impaired markets
• So that they can return to their normal functions
• The decline in financial frictions lowers the real interest rate for investments

Question 24

Explain asset purchases and quantitative easing a the ZLB

Answer 24

• In the case CBs lower financial frictions by lowering credit spreads through the purchase of private assets

• Though the fed took action
○ The negative aggregate, demand shock to the economy from the global financial crisis was so great
○ The Fed’s quantitative (credit) easing was insufficient to overcome it
○ Fed was unable to shift AD curve all the way back to equilibrium
○ Economy still suffered a severe recession

Question 25

Explain Management of expectations at the ZLB

Answer 25

• Lowers financial frictions and the real interest rate for investments
• Can lead to both:
○ Rightwards shifts in aggregate demand as shown in figure 12
○ A shift in the short run AS curve by raising expectations of inflation as shown in figure 13

Question 26

Draw the diagram for the effects of management of expectations (AD/AS)

Answer 26

see notes

1. expected inflation rises, shifting AS upward
2. Increasing output and inflation

Question 27

Summarise the ZLB briefly

Answer 27

1. empirical evidence of the nonconventional monetary policies used by CBs
2. When the nominal policy rate hits the floor of the ZLB:
   - The self correcting mechanism that returns the economy to full employment is no longer operational
3. At the ZLB, in order to boost output and inflation, monetary policy makers turn to nonconvetional policies
4. liquidity provisions
5. asset purchases and QE
6. management of expectations (forward guidance)