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Feb 21st | 13.35 GMT
MACROECONOMICS
The Money Supply Dilemma - Governments's Response To Covid
By: A SWEENEY | Updated, Jan 15th, 2021
Overview
As the Coronavirus pandemic developed, governments across the world were forced to enforce extreme measures in an attempt to support the economic fall out of national lockdowns. With rising unemployment and dampened CPI/GDP figures, it was clear governments would have to step up and support the economy in times of need.
With sudden shocks in the short run, government's rely on monetary policy to act as an instant response to support economic slumps. Central Banks have several policy options at their disposal and in the case of 2020 and the coronavirus, they pulled out all the stops; dropping interest rates and increasing their asset purchases through Quantitate Easing (QE).
So what is QE and how does it work?
QE is a tool used by central banks with the ultimate goal of stimulating economic growth. In periods when interest rates are already very low, they can turn to QE to assist further;
1) The Central Bank create digital money (increasing supply) and use this to buy government debt in the form of bonds; you may have heard of this referred to as 'asset purchasing'.
2) Interest Rates Fall - the asset purchasing from the CB drives bond prices higher which due to the negative correlation in prices and yields, the rates (yields) on those bonds fall, which in turn lowers interest rates offered to households on loans, mortgages etc.
3) Increases Borrowing and Consumption - cheaper debt for household encourages further investment and spending giving the economy a kick-start.
Money Supply and Inflation
According to 'The Quantity Theory Of Money', increases in money supply leads to a proportional rise in prices, ie; inflation. Although, critics argue that prices are sticky in the short run therefore inflation does not rise as quickly or as proportionately to the rate of money growth. Furthermore, it's not uncommon after economic downturn to witness an inelastic demand for money; that is when businesses prefer to save rather than invest as they may expect aggregate demand in the economy to remain low. In such instances, this creates a liquidity trap in the economy where eventually increases in money supply become ineffective beyond a certain point; businesses propensity to save is higher than to spend, similar problems occur in households with spending habits.
In relation to the most recent critsims on Central Banks response to Covid, theory and history shows us that even the most generous stimulus packages offered through QE and low rates does not always spark growth. Of course, in the short run it can give a boost to the recovery but growth is not linear and there may come a point when it becomes relatively ineffective, which would explain the Central Banks lack of concern over inflation for the time being.
Money Supply and Foreign Exchange
As money supply increases, the short run implications are usually a depreciation in the domestic currency. This was certainly the case in the UK where the pound dropped nearly 13% in just two weeks against the US dollar. However, interestingly there was a quick recovery in pound in the proceeding months, therefore the long run effect of money growth was not negative as first suggested. Economic theory would call this 'restoring equilibrium'.
In the long run markets and economies have a way of correcting sudden shocks, and the short run effects are often undone. In 2009 after the financial crisis, we saw that Monetary expansion didn't actually increase money supply - yes the money was created but it was
held as reserves in the banking system rather than being loaned out to businesses and households. As such, there was no real increase in supply causing pound devaluations.
History has a habit of repeating itself in economics and in financial markets, however In the case of the Covid pandemic, it would be safer to assume that there has been real money growth in numerous economies across the world, but for some, rather than having a low marginal propensity to consume, it would be more appropriate to describe the situation as a low 'ability' to consume as many nations are still experiencing strict lockdown measures. Similarly to the Great Recession, the money supply increase has yet to cause any lasting damage to currency valuations, perhaps because although there is money growth, households and business still do not have surplus money, and so there is little excess in circulation.
The Bottom Line
The Covid pandemic has cause mayhem across the world and has set unprecedented challenges to the financial system. Responses from the Central Banks will always be susceptible to critism however with entire nations confined to their homes, it's hard to see many alternatives. The performance in the financial markets has been consistent with economic theory for the time being however the massive rescue packages will eventually take its toll on current account balances and countries will eventually need to rectify issues over the next decade through further fiscal measures.
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