Earlier this
month of May the Euro-stat office released macroeconomic data regarding GDP
growth, which was at 0.2% for the month of April, weaker than expected, and
inflation at 0.7%. In contrast to the Euro-zone, Germany reported GDP of 0.8%,
with the driving force behind this positive growth to be Consumption and
Government spending.
The other
strong economy of the Euro-zone, France, is dragging with declining Investments
and declining Consumption. The European Central Bank (ECB) announced that it
would reduce interest rate, and upon the news, the Euro currency took a dive.
It is
interesting to see the different monetary policy approaches between the ECB and
that of the US, the FED. The ECB maintains a contractionary approach of
monetary policy at least for now. Maybe the upcoming elections for the European
Parliament this weekend changes things. I doubt it since Germany is the
predominant economic power in the EU. As for the US FED, it looks as if lower
interest rate, or expansionary policy, has helped somewhat the economy. The FED’s
balance sheet was announced this past week, with assets worth $4.3 trillion, up
by 29% since last year. In June the FED is expected, if all other things are
equal, to reduce yet further interest rates by 10 – 20 basis points. With the
new head of the FED, a different approach to policy is seen. The FED is expected to reduce its balance
sheet in 2015, and is expected to continue to reduce the monthly bond buying
stimulus program, otherwise known as Quantitative Easing (QE).
But what is
QE? The FED thus far has had an aggressive approach to economic policy to
stimulate the economy. Monetary policy plays an important role since changes in
the money supply contracts or expands an economy.
QE is when
interest rates have reached to such a low level, close to zero, that in order
to stimulate the economy, banks hold on to the money provided by the central
bank from Open Market Operations in reserve. In other words, they do not give
out loans. This is what is happening in Europe, since they are worried about
the future.
Transmission
mechanism is when a five step mechanism illustrates how Open Market Operations
can be used to close a recessionary gap or an inflationary gap. An example is
an economy with high inflation but low unemployment. The FED steps in and raises
the Reserve Ratio by selling government bonds, the amount of money required to
be kept on deposit at the FED by commercial banks increases, money supply declines,
interest rates rise, investment declines because of crowding out (excludes
private investment), aggregate demand declines, inflation declines.
Before going
forward with the tools available to central banks, I will like to briefly mention
that, central banks are public institutions that lend money to commercial
banks. Most central banks have a dual mandate: control inflation and GDP growth
policy. Others have a single mandate: pursue only inflationary policy.
Central Banks
set the money supply not the interest rates. The money supply intersects with
the demand curve to get the interest rate available in the market.
The three
tools available to central banks are: the discount rate, the reserve ratio, and
Open Market Operations. The discount rate is the interest rate it charges
commercial banks to lend them. The reserve ratio is the percentage of total
demand liabilities that commercial banks must maintain in a special reserve
account with the central bank. Open Market Operations, is the buying and
selling of bonds from commercial banks.
It is worthwhile
to mention that there are several types of money, M1, M2, M3. M1 is made up of
cash, checking accounts and travelers checks. M2 is M1, plus savings accounts,
time deposits, money market mutual funds. M3 is M1, + M2, and short term
assets.
Interest rates
are the payment made for the use of money, or, the price of money. There are
three reasons why interest rates differ. First, is the maturity, from overnight
to 30 year home loans. The longer the term of the loan, the higher the
uncertainty, the higher will be the interest rate for compensation. The second
is the degree of risk. Municipal bonds, countries with high debt, junks bonds,
are riskier investments, thus higher interest rates. And the third is liquidity,
an asset that can be converted to cash. Illiquid assets like loans have higher
interest rates.
Two major
determinants for the demand of money are transactions demand, and asset demand.
Transactions demand is the use of money by consumers, businesses, as a medium
of exchange. Households use it to buy products, business for paying salaries
and raw materials. There is also a speculative side, which is asset demand. Holding
money as a store of value because one perceives speculation, that is, a better
investment opportunity will appear, provides no rate of return. There is an
opportunity cost for foregoing interest that could have been earned by lending it
and the loss of value by eroding its value during inflation.
The FED
conducts monetary policy through its OMC. It uses three major policy
instruments: 1- setting the reserve ratio (RR), the least policy tool used. The
FED can increase the Money supply (M) by lowering the RR, or decrease M by
raising RR. Its primary function is to insure that commercial banks do not fall
below a safe level or reserves with the FED, and thereby undermine the
stability of the system.
The discount
rate is the interest rate the FED charges banks when they borrow money. Lowering
the discount rate makes it cheaper for banks to borrow, and expand the money
supply by increasing lending. Raising the discount rate makes it more expansive
for banks to borrow from the FED, and thus, as we said, it is contractionary policy.
OMO is the
buying or selling of government bonds to expand or contract the money supply. The
process is that the Federal Open Market Committee (FOMC) buys government bonds
from the public and pays for the bonds with a FED check. The sellers (banks, financial
institutions, mutual funds, insurance companies, public, etc...) deposit the
check to a commercial bank. The commercial bank deposits the checks at the
regional FED bank as reserve credit. This expands its reserves.
If the FOMC
votes to sell say $1 billion of T bills, this reduces the money supply, and
drives up interest rates and slows the economy. The bonds are sold in the open
market to dealers. They, in turn, resell them to the institutions mentioned
above. The purchasers buy the bonds by issuing checks to the FED, drawn from an
account in a commercial bank. This way the FED reduces the money supply. The
bank, in turn, will reduce its balance of reserves with the FED. This reduces
reserves in the entire commercial banking system by the amount of the check.
GDP is the
total market value of all goods and services produced in the economy in a given
year. The equation for GDP is GDP= C + I + G + (X – M). Inflation is the
increase of prices of a basket of goods the consumer buys. C is consumption,
which is the biggest composition of the GDP equation, and in the US it is
composed of 75%.
These components affect the GDP for an
economy. In an economy there is a circular flow as shown in the graph. If
consumers decide to increase their savings, this is considered as a leakage in
the flow. If money is coming in to the flow, it is considered as an injection
in the circular flow. Investments are considered as injection into the system.
If leakages are > injections, the economy will decline. Above we mentioned
that the Euro-stat reported that France’s consumption and Investments declined
in the past quarter. Its GDP has declined as well.
