Quantitative Easing

Background

During the current financial market meltdown, banks were holding the collateral for the loans which were considered to be of low quality and when the borrower defaulted, banks were not be able to recover the loan amount. Banks became too much cautious while making the new loans to the businesses. This created the liquidity crunch in the economy due to uncertainty. The money released by the central bank could not reach the business which were cash strapped and need money for the operations; credit market became frozen. The reason is that due to uncertainty banks were not willing to lend the money fearing that businesses will default over the loans.

Moreover, the uncertainty was so much that the banks did not even lend to each other. The central bank cut the federal funds rate to facilitate banks to lend to each other and let the credit markets free up. The rate was reduced to 0-0.25%. Banks started raise the funds at this rate and invest in long term Treasury securities, yielding 2-3% return, which are considered to be safe and add certainty to the repayment. This process returns the money released by the central bank back to itself defeating the purpose of increasing the liquidity in economy. The businesses get deprived from the liquidity.

Added function of Central bank

The pipes which deliver the money from central bank to the business are either broken or clogged. Now what central bank can do? Either increase the flow or mend/create new pipes.

The central bank starts to buy the toxic assets (low quality MBS, CDO, CLO, Bank loans to bankrupt companies, etc.) of the banks which are kept as collateral for existing loans. With the default risk transferred to the books of the central bank, banks can look out for loans to the economy.

Furthermore, central bank starts to buy the treasuries in open market operations. The demand of the treasuries brings the yields down which acts as disincentive to the banks. To generate the revenues, banks start to look out in the wider economy (companies, businessmen, etc.) which can give 5-8%.

With these two processes the central bank can print currency as much as it wants to induce in the economy. This is called Quantitative Easing.

Downside: Even after buying the treasuries from the market and toxic assets from the banks, banks may not loan to the businesses. This will devalue the currency which will make the exports more competitive. But if the currency is too much depreciated, market will start selling it leading the further problems.

Effects of Money Laundering on Economy

Effects on Economic Growth

1. Direct Effects: Money laundering distorts the investments and depresses the productivity. Diverting resources to less-productive activity, and by facilitating domestic corruption and crime, which in turn depress economic growth. For developing countries, the diversion of such scarce resources to less productive domestic assets or luxury imports is a serious detriment to economic growth.

2. Effect on Corporate competitiveness and Taxation: Money laundering has a bearing on taxation and small business competition. Laundered money is usually untaxed, meaning that the rest of the people ultimately have to make up the loss in tax revenue. Furthermore, legitimate small businesses cannot compete with money laundering-front businesses that can afford to sell a product cheaply because their primary purpose is to clean money, not turn profit.

3. Effect on Interest and Exchange Rates: Money Laundering has adverse consequences on the interest rates and the exchange rate volatility particularly in developing nations and dollarized nations. It complicates the government effort to manage the economic policies. It affects the income distribution, contaminated the legal transactions, and has potential to destabilize the economy by inefficient movements, which reduces the GDP growth.4. Effect on Foreign Investment: Although developing economies cannot afford to be too selective about the sources of capital they attract, but postponing action is dangerous. There is a damping effect on foreign direct investment when a country’s commercial and financial sectors are perceived to be subject to the control and influence of organized crime. For business friendly environment these impedances have to be weeded out.

Effects on Financial Sector

Since financial institutions are critical to economic growth, reputation and confidence plays an important part in the developing countries.

1. Customer Confidence: Reputation and integrity are valuable assets of a financial institution and the perceived risk to depositors and investors from institutional fraud and corruption is an obstacle to such trust. When customers are defrauded by the corrupt individuals within the institutions it causes loss of business for the financial institutions. Prudential risks to bank soundness, contamination effects on legal financial transactions, and increased volatility of international capital flows and exchange rates due to unanticipated cross-border asset transfers.

2. Dampening of Entrepreneurial environment: Strong financial systems are incubators of entrepreneurial growth. For developing nations, technological change is often associated with the investment and new machinery. To adopt the more productive technologies from advanced nations requires entrepreneurship. At the most fundamental level, innovation and technology thrive when property rights are clear and taxes and other drains on profits (such as corruption) are low and predictable.

3. Investment: The nations in which crime and corruption are prevalent, investors are reluctant to invest and obtain the ownership.

4. Money Laundering erodes financial institutions themselves due to vulnerability to corruption by criminal elements seeking to gain further influence over their money-laundering channels.

Effect of Money Laundering on Cost of Capital:

When Money Laundering takes place, the capital is reduced due to which the supply curve of capital moves towards the left. In this case due to the scarcity of the capital (credit crunch even when the central bank is infusing cash in the financial system) available the cost of capital increases.

As can be seen from the various money-laundering mechanism typologies reports, money laundered through channels other than financial institutions is often placed in what are known as

"sterile" investments, or investments that do not generate additional productivity for the

broader economy.

Effect on Four Wheels of Growth

A developing country requires vast amount of capital and accumulation of capital requires a sacrifice of current consumption over many years. When money laundering takes place, the capital is depleted over the time. The money which could have been used to increase the productivity of the labour is now diverted by the antisocial elements to suffice their selfish interests. The lack of capital reduces the improvement of human resources and technology.

Developing countries are concerned with the quality of labour available. Quality of the labour can be increased by improving health and imparting skills by providing education. Money laundering indirectly affects the labour productivity by providing them low capital to improve the skills and improve the health.

Social and political costs of money laundering, if left unchecked or dealt with ineffectively, are serious. Organised crime can infiltrate financial institutions, acquire control of large sectors of the economy through investment, or offer bribes to public officials and indeed governments.

The economic and political influence of criminal organisations can weaken the social fabric, collective ethical standards, and ultimately the democratic institutions of society. In countries transitioning to democratic systems, this criminal influence can undermine the transition. Most fundamentally, money laundering is inextricably linked to the underlying criminal activity that generated it. Laundering enables criminal activity to continue.

To increase the Aggregate Production Function technological enhancement have to be done in the economy. Innovation of new product and services improve the productivity of the economy. When the availability of the capital is less then investment in R&D becomes difficult. Money laundering impedes the rate of output growth.

In all Output, Q= =Tf(K,L,R) is reduced by the corrupt Monet laundering practices

References:

http://www.fatf-gafi.org/

www.centralbank.org.

The Central Bank

Financial systems in an economy transfer the resources over space, time and sectors. The flow of funds in financial systems occurs through financial markets and financial intermediaries. It is a circulatory system that links together the goods, services and finance in domestic and international markets. A financial system encompasses the markets, firms and other institutions which carry out the financial decisions of household, businesses and the governments. Important parts of the financial system are money market, market for fixed interest assets, stock markets for the ownership of firms, and foreign exchange markets.

Government can carry out the macroeconomic policies which to increase the revenue generation capability using the mechanisms to spur domestic investment and economic growth. To conduct the monetary policy by influencing financial conditions in pursuit of low inflation, high employment and stable financial systems a nation requires a strong central bank. Central Bank has four major functions

1. To Conduct the monetary policy by setting the short term interest rates
2. To maintain the stability of the financial system and contain the systematic risk as a lender of the last resort
3. To supervise and regulate banking institutions
4. To provide the financial services to banks and the government

Central bank can use following policy instruments to influence the financial conditions:

1. Open market operations
2. Providing the discount window for borrowing by the banks and primary dealers
3. To impose the reserve requirements for depository institutions

Money transmission system: Process by which monetary policy undertaken by the central bank interacts with the banks and the rest of the economy to determine the interest rates, other financial conditions, aggregate demand, output and the inflation:

1. The central bank announces the target short term interest rate chosen in accordance with its objectives and the state of the economy.
2. The central bank undertakes daily open market operations to meet are interest rate target.
3. The interest rate target and the future financial condition expectations determine the short and long term interest rates, asset prices and the exchange rates.
4. The level of interest rates, credit conditions, asset prices and exchange rates affect the investment, consumption and the net exports.
5. Investment, consumption and the net exports affect the path of output and inflation through the AD-AS mechanism.

The financial sector plays an important part in economic growth as it can reduce the cost of acquiring information, conducting transactions and facilitating savings mobilisation. By providing these services, the financial sector can enhance resource allocation and increase aggregate savings.

Aggregate Supply & Aggregate Demand

Aggregate Supply

AS refers to amt of goods and services produces in an economy.
AS = f(Price Level)
In short run, inputs are fixed and in long run all factors of production can be adjusted. SRAS is constructed holding the money wage(not the real wage) constant.
Key factor in workers' wage demand is expectation for future inflation rates. If expectation for future inflation rates increases then workers demand higher wages
=> Employers produce less at each price level when wages are higher => decrease in SRAS

LRAS: It is the supply of G&S at each price level when inflation expectations=Actual inflation
Increase in inflation that does not change the workers' expectations => doesnt change the SRAS
Change in actual inflation keeping the wages constant => movement along the SRAS curve to temp disequilibrium situation.
In LR, inflation expectations=Actual inflation => Economic production at full employment GDP(LRAS). As the inflation expectations adjust and equal Actual inflation, the SRAS curve shift in a way that the equib shift towards the LRAS.

LRAS is not affected by the price level, bur depends on:

1. Quantity of Labor in the economy
2. Quantity of Capital(productive resources) in the economy
3. The Technology that economy possesses

Movement along the SRAS curve only when the prices of G&S are allowed to vary keeping the wage rate and price of the other productive resources constant in short run.
When prices of G&S fall => businesses have incentive to increase the expand the production which can increase the real GDP above full-employment level(LRAS).

SRAS & LRAS will shift when full emp quantity of labor changes, amt of available capital changes or as technology improves the productivity capital, labor, or both.

If wage rate or other production input change => shift in SRAS.
Factors that change the money wages

1. Unemployment: It increases=> lower wages due to oversupply of labor.
2. Inflation expectations

Aggregate Demand

AG = C+I+G+X (Exp-Imp)

At higher price levels CIG Exp will are decrease. AG is downward sloping:

1. When price levels increase=> individual's real wealth decreases, since they have less accumulated wealth, they will spend less (Wealth effect).
2. When price levels increase=> int rates will increase > Decrease in I and C as consumers delay the consumption of consumer durables since cost of consuming now instead of later has increased.
   

Shift in AD:

1. Expectation about the future incomes, inflation and profits
2. Fiscal and Monetary policies
3. World economy

Increase inflation > increase in AD as consumers accelerate purchases to avoid higher prices in the future.Expectation of increase in income will cause consumption to increase.Increase in expected prices will lead businesses to increase investment in plant and equipment.
Effect of world economy: As the foreign incomes increase, demand for country's exports will increase => increasing X. If country's exchange rate increases (currency appreciates),goods will be costlier to foreigners and exports will decrease. This will decrease imports also since, imported goods will be costlier for domestic market.