Unconventional Monetary Policy: Quantitative Easing (QE)

Introduction to Unconventional Monetary Policy

• Unconventional monetary policy involves measures other than changes in the cash rate to influence the level of aggregate demand (AD) and domestic economic activity.
• Used particularly when conventional monetary policy (adjusting the cash rate) is ineffective, often when interest rates are already near zero (the “zero lower bound”).

KEY TAKEAWAY: Unconventional monetary policy is employed when traditional methods of monetary policy are insufficient to stimulate the economy.

Quantitative Easing (QE) - An Example

• Quantitative Easing (QE): A monetary policy where a central bank purchases financial assets (e.g., government bonds, corporate bonds) from commercial banks and other institutions to inject liquidity into the money market and lower interest rates further out along the yield curve.
• RBA Implementation Period: March 2020 - February 2022

How QE Works

1. Asset Purchases: The RBA purchases government bonds (or other assets) from commercial banks.
2. Increased Liquidity: This injects cash (liquidity) into the banks’ balance sheets, increasing their reserves.
3. Lower Interest Rates: With more reserves, banks are more willing to lend money, which puts downward pressure on interest rates across the economy (beyond just the cash rate).
4. Stimulated Lending and Investment: Lower interest rates encourage borrowing and investment, boosting AD.
5. Signalling Effect: QE can also signal the central bank’s commitment to low interest rates, further influencing expectations and behavior.

RBA’s Objectives for Implementing QE

• Lower borrowing costs: By purchasing government bonds, the RBA aimed to lower longer-term interest rates, making borrowing cheaper for businesses and households.
• Increase liquidity: QE aimed to ensure that banks had sufficient liquidity to continue lending to businesses and households.
• Support asset prices: QE was intended to support asset prices, such as housing and shares, which can boost wealth and confidence.
• Boost confidence: QE aimed to signal the RBA’s commitment to supporting the economy, which could boost confidence among businesses and households.

Impact and Transmission Mechanism

• Savings and Investment Channel: QE lowers interest rates, encouraging borrowing for investment and discouraging saving.
• Cash Flow Channel: Lower interest rates reduce the cost of servicing debt, improving cash flow for households and businesses.
• Asset Prices and Wealth Channel: QE can increase asset prices (e.g., housing, stocks), leading to increased wealth and confidence, which then boosts consumption.
• Exchange Rate Channel: QE can lead to a depreciation of the Australian dollar (AUD), making exports more competitive and imports more expensive.

Effects on Macroeconomic Goals

• Economic Growth: QE aimed to stimulate economic activity by lowering borrowing costs and increasing liquidity.
• Inflation: By increasing AD, QE aimed to support inflation, moving it towards the RBA’s target range of 2-3%.
• Unemployment: Increased economic activity leads to increased demand for labor, reducing unemployment.

Limitations and Risks of QE

• Effectiveness: QE’s impact can be uncertain and depend on various factors, such as business and consumer confidence.
• Inflation: QE can lead to excessive inflation if AD increases too rapidly.
• Asset Bubbles: QE can inflate asset prices, leading to unsustainable bubbles.
• Distributional Effects: QE can disproportionately benefit those who own assets, potentially increasing inequality.
• Moral Hazard: QE might encourage excessive risk-taking by banks and other institutions, as they expect the central bank to intervene if things go wrong.

EXAM TIP: When discussing QE, always link it back to its intended effect on aggregate demand and Australia’s macroeconomic goals.

VCAA FOCUS: VCAA loves to ask about the transmission mechanisms of monetary policy. Make sure you understand how QE affects each channel.

RBA’s Stance on QE

• The RBA viewed QE as a complement to its conventional monetary policy (cash rate reductions) during the COVID-19 pandemic.
• The RBA ceased its QE program in February 2022, citing improvements in the economy and labor market.

COMMON MISTAKE: Students often confuse QE with simply lowering the cash rate. Remember, QE involves direct asset purchases to inject liquidity.

STUDY HINT: Create a flow chart to visually represent how QE impacts the economy through each transmission channel.