Money Supply / QE / Interest Rates
Public Sector Net Cash Requirement
Represents the annual fiscal deficit
Represents the shortfall between the public sector revenues and expenditure
A measure of the public sector's net financing requirement, quantifying the amount the government needs to borrow to cover all of its expenditure requirements - that is the gap between tax receipts and government spending
Can be measured as an amount of money or a percentage of GDP
Governments have a number of methods to finance the PSNCR
Increasing the narrow money supply (producing more notes and coins)
Issuing government securities
Overseas borrowing
Money supply
May be defined as the total quantity of money in circulation within an economy
The measure of money supply is important because of its influence on
Price levels
Inflation
The business cycle
Controlling the money supply is important in the control of an economy. This stems from the fact that money is used in nearly all economic transactions. An increase in money supply leads to
There are a number of different measures which may used in relation to the level of money supply. The specified measure used depends on the country in question and although M0 is obsolete in the UK it does not prevent it being used in other jurisdictions or being re-introduced in the UK at a later date. The rage is generally from M0 to M4
M0: also referred to as the monetary base. The amount of money in circulation in notes and coins plus the banks' till money and the banks balances at the Bank of England
M1: Includes all the components of M0 plus those assets which can be converted to cash at very short notice comprising those financial assets which can be used directly as a means of payment however they may additionally be used as a store of wealth
M2: Equal to M1 plus sterling time deposits with up three months notice or up to two years fixed maturity
M3: A very broad measure of the domestic money supply that includes M2 items plus any large time deposits and money market fund balances held by institutions
M4: The main broad measure of money supply in the United Kingdom. It includes everything in the M3 figure plus:
- other deposits with an original maturity of up to five years
- other claims on financial institutions including bank acceptances
- Debt instruments issued by financial institutions including commercial paper and bonds with a maturity of up to five years
- 95% of the Major Financial Institution difference
Lowering of interest rates
An increase in economic activity
A rise in stock markets
An increase in consumer confidence
Expansion of an economy
A rise in prices
Inflation
Interest rates
Interest is the charge made for a loan and is usually expressed in terms of percentage per year
The higher the interest charge, the more expensive it becomes to borrow money
The level of interest can therefore be used to indirectly control an economy
If an economy enters an inflationary period due to increasing demand as a result of money becoming easy and cheap to borrow then the raising of interest rates eventually reduces the demand pressure through the cost of borrowing na making saving money on interest bearing bank and building society accounts more attractive
When an economy is likely to move into recession, a reduction of interest rates should stimulate demand in order to correct the movement
A change in interest rates is an indirect tool as it takes several months to have the desired impact on an economy
Quantitative Easing
An instrument a central bank uses to bring down interest rates for companies and households by creating money electronically in the economy
A form of monetary policy implement if it is deemed necessary by a central bank to stimulate an economy when interest rates are already extremely low
The aim of QE is to kick start an economy in order to reach a specific inflation target
It is the purchasing of assets using money that has been created electrically
Creates money electronically in order to make large purchases of assets from the private sector including pension funds, domestic banks and the assets will consist of government bonds (gilts) which have a high degree of liquidity
As the asset purchases are in huge nominal volumes, this will push up the price of these assets and consequently reduce the yields. This is supposed to encourage those to sell the assets to use the money to buy other assets with higher yields such as equities or corporate bonds
As more assets are bought, their prices will rise and their yields will fall, causing yields in general to fall. It is hoped that the companies issuing these securities benefit from cheaper borrowing and consequently they will borrow, spend and investment more in the economy as a whole
Those selling assets have more money in their bank account a a result. Commercial banks can use these new funds to finance new loans, encouraging more spending and investment
If inflation appears to be too high, the assets purchased may then be sold through quantitive easing to reduce the amount of money and spending in the economy
The mechanics are as follows
The central bank in the UK will purchase financial assets usually government bonds (gilts) with money it has created electronically
It then uses this electronic money to buy these financial assets from investors such as banks or pension funds
This increases the overall amount of useable funds in the financial system. Making more money available is supposed to encourage financial institutions to lend more to businesses and individuals
It can also push interest rates lower across the economy even when the central bank's own rate are just about as low as they can go. This is turn show allow businesses to invest and consumers to spend more, kick starting the economy
Disadvantages
It is difficult to manage and understand whether or not it has actually been effective
QE pushes up the market price of gilts and reduces the yield or interest rate paid out to investors. Investors have to pay more to get the same income
If market interest rates are lower, this will depress the value of a currency because it becomes less attractive to foreign investors
It has been suggested that the cash injected by the bank went to the more affluent
A key issue is that pumping more money into the economy could ultimately lead to an inflation or hyperinflation scenario
When inflation is close to zero, upward pressure on prices can be seen as beneficial, however some politicians and economists have opposed the idea of QE in principle, as they consider that in the longer term there is a risk that it could create too much inflation
The main risk is hyperinflation
Advantages
The extra money provided by the central bank should eventually boost spending
Unlike interest rates which can only drop to zero, there is no limit to the amount that a central bank can provide but the chance of inflation has to be monitored
With low interest rates, nothing else is likely to work
If it is effective, QE may shorted a recession and prevent deflation