Wednesday, March 25, 2009

Why Quantitative Easing

These two graphs give a good reason why the UK is pursuing a policy of quantitative easing.

UK Money Supply
source: M.Oracle

The first shows the Money supply growth adjusted for velocity of circulation. Basically, in a recession, the velocity of circulation falls (people spend less so money changes hands less frequently) Therefore, the effective money supply is much less that the stock of money supply.
This shows the UK has effectively a negative growth in money supply.

The next graph shows the UK experiencing an inflation rate of 0%. Admittedly it is the RPI measure that is 0%. CPI inflation is still 3%. RPI is much lower because it includes mortgage interest payments which have fallen because of the drop in interest rates.

UK Inflation

Source: ONS

Nevertheless what this graph doesn't show is the expected fall in CPI inflation due to the large volume of spare capacity in the economy. Given the spare capacity in the economy, deflation is a real problem at the moment.

Given the scale of quantitative easing and increasing the money supply, inflation could be a problem in 12 months time. Removing the excess money supply when the economy recovers will be no easy feat. But, we will have to deal with that problem when we come to it. The first problem is deflation.

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