Thursday, March 12, 2009

Money Supply Growth

Through buying assets the Bank of England is increasing the money supply. If we increase the money supply by £100bn what happens?

1. Depends on Money Multiplier

Typically, banks keep a certain reserve in the form of cash.

For example, if they have deposits of £100bn. They may decide to keep 2% or £2bn in the form of cash deposits in the bank. They will lend out £98bn in the form of loans to customers (mortgages, personal loans e.t.c). This enables the bank to make more profit. Because they earn interest on the money that is deposited.

Therefore, if you increase the money supply by £10bn. They may decide to keep £0.2bn of this in cash and lend an extra £9.8bn. This leads to further bank deposits and further bank lending.

Therefore, an initial increase in the money supply can lead to a much bigger increase in the money supply. This is known as the money multiplier. If banks have a deposit ratio of 2%, it means that the final increase in money supply will by 50 * the initial increase in bank lending. If the reserve ratio was 20%, the money multiplier would be 5.

This means that quantitative easing could have a significant impact on increasing money supply in the economy. However, this assumes normal lending conditions.

Since the credit crisis, banks have been trying to build up their cash reserves. Therefore, the problem is that this increase in the money supply may simply be hoarded by commercial banks. Rather than lend it they may just use it to improve their financial position and recover past losses.

It is probable that the Banks will lend some of the money supply increase, but the money multiplier will be very low. One important issue is that we simply don't know how much the policy of money creation will increase the money supply.

Furthermore, money supply figures are notoriously unreliable. Money supply figures can be distorted by financial changes making it difficult to know measure what is happening.

2. Quantitative Easing and Bond Yields

Quantitative easing will impact the interest rate (yield) on government bonds and commercial bonds. The Bank of England will buy securities, therefore their price rises and the interest rate declines. (relationship between bond prices and interest rates)

This lower interest rate may provide a monetary stimulus. As it becomes cheaper for firms to borrow through issuing commercial bonds. This impact may be bigger than the effect of increasing bank cash deposits.

Quantitative Easing and Value of Pound

Quantitative easing increases the risk of inflation, which makes the Pound Sterling less attractive.

Quantitative easing reduces interest rates on UK securities making it less attractive to hold UK securities and bonds. This will reduce demand for holding pounds. Already there has been a widespread selling of UK assets, reducing the Pound.


James said...

Haven't Japanese interest rates been below 1% for over a decade?

Won't that happen here?

And is there any reason why interest rates won't stay this low for decades to come?

Tejvan Pettinger said...

It really depends on the impact of quantitative easing and other policies. If inflation stays below 1% then we will probably have interest rates close to zero. It really is hard to say how long that will be for, at moment

Anonymous said...

So is this kind of action called "supply-lead" governance?