Custom «The Impact of Quantitative Easing on Aggregate Demand» Essay Paper

Quantitative easing has become a common economic phenomenon in developed nations since the onset of the global financial crisis. Central banks and the Federal Reserve employ quantitative easing in their respective countries to spur aggregate demand by stimulating household and business consumption and investment (Wood 6). Studies show that quantitative easing lowers interest rates to discourage savings, and encourage borrowing for spending and investment purposes. Quantitative easing also increases the money supply in an economy, which increases the aggregate demand in the form of increased investment and consumption.

Aggregate demand is the total of spending in net exports, the national income accounts; government expenditure; investment, and consumption. Aggregate demand increases in an expansionary economy and decreases in a deflationary economy (Baumoland Blinder655). In a deflationary economy, policymakers focus on policies aimed at increasing credit availability, reducing interest rates, and expanding money supply. Studies also show that expectations for higher income boost consumer confidence, which spurs increased consumption and aggregate demand.

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There is irrefutable evidence that the global financial crisis had and continues to have a negative impact on the economy of the United States of America. The nation’s aggregate demand has been subdued for almost four years because of high unemployment levels, which have eroded consumer and investor confidence leading to lower investment and spending behavior. The government found it necessary to inject additional money into the system to discourage saving and bolster investment and spending.

In quantitative easing, central banks create new currency, which they use to for purchasing government and private securities from the public. This repurchase of government securities and other financial instruments injects money into the economy (Wood 7). Central banks are faced with new challenges when interest rates hit exceptionally low levels yet consumption, and investment levels remain low, and under such circumstances, they can no longer pump liquidity into the economy by buying financial instruments forcing them to print money like has been the case in the United States of America.

The Federal Reserve has had three rounds of quantitative easing since the global financial crisis in an effort to reduce interest rates, and increase the level of lending and spending activity in the economy. The Federal Reserve made the first purchase of the country’s mortgage and treasury bonds in 2009, with a purchase of $1.75 trillion using new money (Wiedemer, Wiedemer, and Spitzer 23). This round of quantitative easing increased the country’s money supply to $2.4 trillion from $800 billion. The aggregate demand activity was not satisfactory, and in November 2010, the Federal Reserve introduced a second round of quantitative easing by purchasing bonds totaling to $600 billion, which increased the country’s money supply by the same amount.

In September 2011, the Federal Reserve announced that it would employ an intervention strategy referred to as “Operation Twist” that was different from quantitative easing in that it aimed at buying longer-term bonds with proceeds from the sale of shorter-term bonds. The government bought long-term bonds amounting to $400 billion from the proceeds of selling short-term debt, which increased the money circulating in the economy.

The Federal Reserve announced a third round of bond purchases in September 2012, but this time, the bank intends to continue buying debt instruments until there is a notable improvement in the economy. According to Saphir, the Committee plans to continue buying additional mortgage-backed securities worth $40 billion per month to promote investment activities by keeping interest rates low (2012).

Studies show that policymakers strive to ensure there is effective money supply in any given economy if the economy is to sustain an adequate aggregate demand. The Federal Reserve’s efforts in quantitative easing successfully stimulated the economy because bond sellers managed to raise money for investment activities at lower interest rates than would have been the case in an expansionary economy (Wiedemer, Wiedemer, and Spitzer 24).

The money injected into the economy through quantitative easing was also invested in the stock market, which boosted investor confidence leading to increased investor appetite, and higher stock prices. Investors enjoyed capital gains following the rallying stock prices, which boosted consumer confidence in spending. The increased investment and spending activity prompted by the injection of the new money stimulated the nation’s aggregate demand substantially.

Quantitative easing has the effect of lowering interest rates in the short-term, which is favorable for businesses because they can borrow for expansion, capital investment, and to hire more employees paving the way for increased consumption as unemployment levels and interest rates fall (Knoop 45). Low interest rate regimes also attract higher levels of borrowing for homebuyers, which increases the aggregate demand.

Government revenues have dropped considerably since the global financial crisis because the high unemployment rates and declining consumption levels have negatively impacted on the amount of taxes collected from businesses and individuals. In spite of the decline in revenue collection, the government has to meet its obligations, and stimulating economic growth is paramount. The nation’s aggregate demand shoots up necessitated by an extensive rise in government’s expenditure following quantitative easing (Wilhelm and Isaak 95).

Studies indicate that, during the process of quantitative easing, central banks buy government securities as well as private debt, which may include foreign debts. When central banks purchase foreign debt issued in their countries, they automatically introduce foreign exchange factors, which subsequently have an effect on the exchange rate and the country’s net exports (Japan 18). Quantitative easing is aimed at increasing the amount of money in circulation, which is likely to weaken the country’s currency, which could increase demand for their exports because they are likely to be relatively cheaper than those from competing countries with stronger currencies.

Supply shocks also have a considerable impact on aggregate demand because they tend to destabilize consumer and business spending patterns, as fears of a recession build up. For instance, the credit crunch that was experienced in the wake of the global financial crisis was followed by a phase of minimal spending as banks became strict on their lending terms, contrary to the case before the credit crunch (Kiley 4). A reduction in money supply pushed interest rates upwards, which exacerbated the situation because businesses and households opted to save rather than to spend or invest. This new trend resulted in massive job losses, further lowering the country’s aggregate demand (Nathaniel and Haughton 264). Undeniably, quantitative easing has been an effective tool in mitigating the adverse effects that supply shocks have on a country’s aggregate demand, and by extension a nation’s economic activity.

Quantitative easing has a notable impact on a nation’s aggregate demand because an increase in money supply reduces interest rates leading to increased borrowing for spending or investment. Low interest rates also discourage saving, and encourages investment into the stock market, which boosts investor and consumer confidence, and stimulates spending. Quantitative easing involving the purchase of foreign denominated assets may lower the strength of the dollar relative to other currencies making exports from the United States of America cheaper and more attractive than those from competing nations. Quantitative easing is arguably an effective tool for stimulating economic growth by spurring aggregate demand, though it is an expensive strategy in the long-run because it could pave the way for runaway inflation (Wiedemer, Wiedemer, and Spitzer 25). It has become a common monetary policy mechanism, but central banks need to use it with caution.