The Bank of England has extended its policy of increasing the money supply through the process of quantitative easing. After the May meeting of the MPC, the Bank announced that it will increase the amount of assets it is prepared to buy under the ‘Asset Purchase Programme’ from £75 billion to £125 billion. At the same time the ECB has announced that it too will embark on a programme of quantitative easing. The press releases and articles below consider the details.
Bank of England Maintains Bank Rate at 0.5% and Increases Size of Asset Purchase Programme by £50 Billion to £125 Billion Bank of England News Release (7/5/09) (see also interview with Bank of England Governor)
Press conference by Jean-Claude Trichet, President of the ECB and Lucas Papademos, Vice President of the ECB ECB Press Release (7/5/09) (you can also watch a webcast of the press conference from this link)
Bank of England and European Central Bank extend quantitative easing Telegraph (8/5/09) (see also)
Economy to get extra £50bn boost BBC News (7/5/09)
A QE surprise BBC News: Stephanomics blog (7/5/09)
European Central Bank opts for quantitative easing to lift the eurozone far Times Online (8/5/09)
Fighting recession in the eurozone Financial Times (7/5/09)
ECB dips toe in quantitative easing water Guardian (7/5/09)
Quantitative easing: The story so far BBC News site video
Questions
- Explain how quantitative easing is conducted by the Bank of England and the ECB.
- Examine what determines the effect of quantitative easing on aggregate demand.
- Is quantitative easing the same as open-market operations?
- Explain how quantitative easing is likely to affect exchange rates.
Retail sales in the eurozone have been falling for several months as the recession deepens. The latest figures show a drop in sales of 4.2% between March 2008 and 2009. But what are the implications for fiscal and monetary policy?
With many eurozone countries worried about growing budget deficits the pressure is on the ECB to cut interest rates. Would this help to halt the decline in sales, or do policy-makers need to go further? The linked articles look at the facts and some of the solutions.
Volume of retail trade down by 0.6% in euro area Eurostat news release (6/5/09)
Brussels doubles EU recession forecasts for 2009 Independent (5/5/09)
Euro zone retail sales in record fall IrishTimes.com (24/4/09)
Record decline in eurozone sales BBC News (6/5/09)
EU businesses say worst of crisis over, urge action Guardian (6/5/09)
ECB Is Expected to Cut Rate to 1%, Enlist Other Tools The Wall Street Journal (6/5/09)
ECB set to cut interest rates to record low of 1% Times Online (5/5/09)
See also
Economic Forecast, Spring 2009 European Economy (European Commission)
Questions
- What determines the level of retail sales?
- What would halt the decline in retail sales?
- Discuss various measures that the ECB could take to stimulate the eurozone economy. Why might it be reluctant to take some of the measures?
The following articles look at a recently published book by George Akerlof of the University of California, Berkeley, and Robert Shiller of Yale. They examine the role of what Keynes called ‘animal spirits’ and is the title of the book.
The motivation to make economic decisions (to buy, to sell, to invest, etc) may not be ‘rational’ in the sense of carefully weighing up marginal costs and marginal benefits. Rather it can be one of over-optimism in good times or over-pessimism in bad times. Just as individuals have ‘mood swings’, so there can be collective mood swings too. After all, confidence, or lack of it, is contagious. This motivation that drives people to action is what is meant by animal spirits.
But are animal spirits a blessing to be nurtured or a curse to be reined in? Should governments seek to constrain them?
An economic bestiary The Economist (26/3/09)
Good Government and Animal Spirits Wall Street Journal (23/4/09)
Irrational Exuberance New York Times (17/4/09)
Animal Spirits: A Q&A With George Akerlof Freakonomics: New York Times blog (30/4/09)
Questions
- Describe what is meant by ‘animal spirits’ and their effects on human behaviour.
- Why may animal spirits make economies less stable?
- How may animal spirits help to explain exchange rate overshooting?
- Discuss whether governments should seek to constrain animal spirits and make people more ‘rational’? Also consider what methods governments could/should use to do this?
In a recession, the government’s budget will go into cyclical deficit as tax revenue falls and government spending on unemployment and other benefits rises. Provided the deficit is purely cyclical, it can be seen as desirable since it acts as an automatic fiscal stabiliser, boosting aggregate demand and helping to pull the economy out of recession. Once the economy returns to potential national income (i.e. a zero output gap), the deficit would disappear. At potential national income (Yp), government expenditure (including benefits) will equal tax revenue. The budget is in balance.
Again, provided that the deficit is only cyclical, discretionary expansionary fiscal policy that further deepens the deficit will not be a problem for public finances in the future. Once the economy pulls out of recession, the discretionary policy can be relaxed and the higher national income will eliminate the cyclical deficit.
But the problem the Chancellor of the Exchequer faced in the Budget (on 22/4/09) was not just one of tackling the recession. The UK economy has seen a massive growth in the structural deficit. His forecast is for the total deficit to be £175bn in 2009. But, according to calculations by the Institute for Fiscal Studies, even when the recession is over and the output gap has been closed, there will still be an annual deficit of around £140bn. This is not cyclical; it’s structural.
So why is there this huge structural deficit? And what is the solution? Will the solution slow down recovery? The following articles look at the issues.
Budget 2009: Tightening the Squeeze? Institute for Fiscal Studies (23/4/09)
We should start by admitting we’ve failed as an economy: Hamish McRae Independent (22/4/09)
Budget 2009: Experts cast long shadow over Darling’s sunny outlook Guardian (23/4/09)
Budget 2009: Economist warns of spending cuts and tax rises Guardian (23/4/09)
The chancellor’s Budget dilemma: Stephanie Flanders BBC News (23/4/09)
For a global perspective on structural deficits, see:
Why the ‘green shoots’ of recovery could yet wither Financial Times (22/4/09)
Outlines of the main Budget measures can be found at:
Budget 2009: Need to know Times Online (23/4/09)
At-a-glance: Budget 2009 BBC News (22/4/09)
Full details for the Budget can be found from the Treasury’s Budget site
Questions
- Explain the terms ‘cyclical deficit’ and ‘structural deficit’.
- Draw a diagram showing how government expenditure (including benefits) and tax revenue vary with national income. The diagram should show the sitation with no structural deficit: i.e. the two lines should cross at potential national income. Illustrate (a) a cyclical deficit where actual national income is below potential national income (a negative output gap) and (b) a cyclical surplus where actual national income is above potential income (a positive output gap).
- Now, on the same diagram, shift the two lines to illustrate a situation of structural deficit.
- Consider whether the government should attempt to increase or reduce the budget deficit at a time of recession.
- Why has the structural deficit become so severe over the past year?
- How quickly should the government set about tackling the structural deficit?
On 7 April, Brian Lenihan, Ireland’s Finance Minister, introduced an emergency Budget. He forecast that Irish real GDP would decline by some 8 per cent in 2009, that consumer prices would fall by 4 per cent (i.e. substantial negative inflation) and that unemployment, already at 11 per cent, would rise further. So what was his solution? Was it a massive fiscal stimulus to boost aggregate demand and turn the economy around? No: it was precisely the opposite. He announced substantial tax increases and cuts in government expenditure? Was this economic madness, or was there economic sense in the measures? The following articles explore the arguments.
Ireland’s shock therapy has got its merits Independent (9/4/09)
Ireland Faces ‘Challenge of Its Life’ BusinessWeek (8/4/09)
Few crumbs of comfort as incomes take severe hammering Irishtimes.com (10/4/09)
Republic’s Budget cuts ‘for the common good’ Belfast Telegraph (8/4/09)
Ireland unveils budget ‘challenge’ Financial Times (8/4/09)
Ireland unveils emergency budget BBC News (7/4/09)
When fiscal stimulus isn’t stimulating: Stephanie Flanders blog BBC News (7/4/09)
Ireland imposes emergency cuts Telegraph (8/4/09)
Questions
- Consider the arguments for and against the fiscal tightening measures adopted by the Irish government.
- Should the UK government also adopt a tighter fiscal stance?
- How important is investor confidence in determining the success of a Budget?