Question

The following questions are concerned with scenarios when conventional monetary policy is ineffective – typically during and in the wake of crisisA) When the central bank chooses to pursue "unconventional" monetary policy it means that conventional expansionary policy is not having its desired effect.What are banks probably doing that is preventing the policies in the previous question from having their intended effect? Why are banks doing this?B) Quantitative easing and credit easing are two complementary variations of unconventional monetary policy. What is quantitative easing and what does it have in common with some conventional policy objectives? How does credit easing try to overcome the constraints arising from the previous question?

Answer 1

Answer:

Consider the following explanations

Explanation:

Question 2a)

Banks are required to keep some reserves with the central banks such that in case of bad times, the central bank would help the banks. However, individual banks are unable to meet the exact number of reserves after conducting their daily lending and borrowing exercises. This further leads to interbank transactions of unsecured loans. If a company defaults in the payment, then the banks associated with it, do not lend in the interbank market because the banks associated with the company will not get the repayments. This further leads to uncertainty for the other banks to lend further. There is a liquidity crunch and banks are facing difficulty in their normal functioning as there is a hindrance in loan making capabilities. As a result, the financial system freezes as no bank is willing to lend to other banks.

In this regard, the intervention of central banks becomes mandatory. The pumping of money in the market is the only way out to stabilize the tension in the interbank market. Although, the central bank intervention will cause a hole in the reserves but to stabilize the financial market is a risk that needs to be taken.

Question 2b)

When the financial system is struggling, the conventional monetary policies would lowering the interest rates, increasing the money supply and aggregate demand in the economy. Primarily three measures are:

Bank rate: It is an indirect method in creating volume in the credit and the initiative lies in the hands of commercial banks. For commercial banks, the cost of credit for the availability of credit is increased. It induces to increase consumer spending and investment made by the firms for increasing growth.

Open market Operations: It is a direct way by the central bank to induce money supply in the economy. For expansionary monetary policy, it is mainly done by selling the central bank securities in the money market for creating more liquidity in the market.

Cash Reserve ratio: The decrease in the cash reserve ratio (reserve that needs to be kept with the central banks), increases the credit of cash reserves, thereby increasing their potential to credit creating capacity.

Question 2c)

The conventional measures of central banks fail to work in times of economic crisis or deep recession because they are not able to create more money supply in the market. As a result, bank reserves are already at a minimum and cannot risk default by lowering if further. The bank interest rates are already lowered and the central banks cannot risk it bringing it to close to 0 because this will lead to a liquidity trap. Once interest rates are lowered close to zero, the economy also risks falling into a liquidity trap, where investment leads to no profits and people hoard money. As a result, the central bank needs to resort to unconventional methods.

Question 2d)

Quantitative easing is a measure that increases the money supply and lowers the long term interest rates by purchasing other securities like to buy government bonds from commercial banks. Moreover, other than bonds, the government can even buy debt instruments (mortgage-backed securities) owned by financial institutions. Quantitative easing is common with conventional monetary policies because it increases the money supply by following open market operations in the purchase and sale of bonds instead of securities and it is a direct way to do it.

On the other hand, credit easing is applied when the central banks start buying private assets such as corporate bonds.