Macroeconomics: Circular flow and Quantitive easing (How QE works:…
Macroeconomics: Circular flow and Quantitive easing
Quantitive easing (QE):
QE involves the Central Bank creating more money and trying to reduce bond yields
The aim of QE is to:
Increase the supply of money
Increase the inflation rate and avoid deflation
Increase bank lending and increase economic growth
How QE works:
Commercial banks sell assets to the Central Bank for cash
Therefore, banks see an increase in their liquidity
The Central Bank uses these extra bank reserves to buy various securities, such as government bonds and corporate bonds
In theory, with more cash reserves, the bank will be more willing to lend to customers. This lending will important for increasing investment and consumers spending.
The Central Bank creates money electronically
Buying assets reduces their interest rate. Lower interest rates on these securities may also encourage banks to lend. Higher lending should help improve economic growth.
Evaluation of QE in the UK:
Future inflation? Some fear that quantitive easing creates the possibility of future inflation because, when the economy recovers, there is excess money supply in the financial system, which may be hard to remove.
Economic growth was low / negative between 2009 and 2012, suggesting QE was of limited effect in boosting economic growth.
Government bond yields did fall, making it cheaper for the government to borrow, through some feared a bond bubble.
Its hard to quantify the effect of QE. At the same time, the UK growth was affected by deflationary fiscal policy and low growth in Europe. Perhaps, without QE, the recession would have been deeper.
Circular flow of income
shows how money flows from households to firms. Then firms pay households wages to produce goods.
measures national income - the total wealth of a country. The circular flow of income shows three ways to calculate GDP
Total national expenditure (consumption and investment)
Total national output (value goods and services produced)
Total national income (wages, dividends)
This is an increase of expenditure into the circular flow of income, leading to an increase in aggregate demand AD. Injections include:
Government spending (G)
Investment (I) - Spending on capital goods by firms
Exports (X): Spending on domestic goods from abroad
: A reduction of money in the circular flow, sometimes known as leakages. Withdrawals can include:
Saving (S): depositing money in banks
Imports (M): Spending on foreign goods
Taxation (T): The government rising money from consumers and firms