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Unconventional monetary policy

By Christopher Bowdler and Amar Radia

Central banks in advanced economies typically conduct monetary policy by varying short-term interest rates in order to influence the level of spending and inflation in the economy. One limitation of this conventional approach to monetary policy is the so called lower bound problem. If the central bank were to try to set short-term interest rates much below zero, then households and companies would choose to hold money in the form of currency instead of depositing it in banks. Following the sharp and synchronised downturn in the global economy that began in 2007, central bank policy rates in a number of countries began to approach zero. Faced with the prospect of the zero bound biting, a number of central banks turned to a range of unconventional monetary policies. Foremost amongst these is what is known as Quantitative Easing (QE), whereby the central bank attempts to stimulate the economy by increasing the supply of money and purchasing assets from the private sector. The Federal Reserve in the United States, the Bank of England, and the Bank of Japan have all undertaken QE of some form. In this article we pose a number of questions concerning these unconventional measures and address these questions based on our own observations and the contributions of leading academics.

Printing US banknotes

We start with a key question: what are the mechanisms through which quantitative easing may encourage private sector economic activity and so substitute for the role of conventional monetary policy at the lower bound? One such mechanism is portfolio rebalancing. When the central bank creates money to purchase assets from the private sector, for example by buying government bonds from pension funds, those investors are left ‘out of equilibrium’ in that they hold large amounts of cash that offer very low returns. This creates an incentive for them to ‘rebalance’ their portfolios buy buying riskier, higher yielding assets, such as corporate bonds. Through this process of portfolio rebalancing, asset prices should increase, and the cost of borrowing should fall. For example, companies who can now issue corporate bonds more cheaply can invest and create jobs.

Another mechanism through which QE can boost the economy is the so-called signalling channel whereby the central bank’s decision to undertake asset purchases reveals to financial markets and the private sector more generally that it intends to keep the short-term interest rates that form the core of conventional monetary policy low for a substantial period of time. This allows households and companies to borrow at reduced interest rates for a longer period of time. We explain these and other channels of transmission in detail.

The exact transmission mechanism of QE is a subject of much debate, with different schools of thought offering a wide range of views. For example, on one hand, a monetarist perspective emphasises that QE works primarily by increasing the quantity of deposits held by agents in the economy or ‘broad money’. On the other hand, under certain assumptions, central bank asset purchases do not affect private sector spending in a class of New Keynesian models. Central banks around the world have also undertaken a range of measures beyond QE. These include forward guidance about monetary policy, large scale liquidity operations, and credit easing policies designed to stimulate bank lending.

Dr Christopher Bowdler is a University Lecturer in Economics and a Fellow and Tutor in Economics at Oriel College, University of Oxford. He is an editor of the Oxford Bulletin of Economics and Statistics and the Oxford Review of Economic Policy. Amar Radia is an economist in the Monetary Analysis directorate at the Bank of England. They are the authors of the paper ‘Unconventional monetary policy: an assessment’, which recently published in the Oxford Review of Economic Policy journal.

Each issue of the Oxford Review of Economic Policy concentrates on a current theme in economic policy, with a balance between macro- and microeconomics, giving a valuable appraisal of economic policies worldwide. While the analysis is challenging and at the forefront of current thinking, articles are presented in non-technical language to make them readily accessible to all readers (such as government, business and policy-makers, academics, and students). It is required reading for those who need to know where research is leading.

Any views expressed are solely those of the authors and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee or Financial Policy Committee.

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Image credit: Printing US dollar banknotes. By matthiashaas, via iStockphoto

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