Ultimate Weapon When All Else Fail – Fiscal stimulus

During severe economic recessions, increasing money supply through monetary policy (cut down interest rate) has failed to stimulate growth and reduce unemployment level. There is one last resort that the government can do to revive the economy, by running budget deficit.

The concept of budget deficit is to spend more than the taxes that have been collected. This is like an individual spend more on credit card than his/her personal income. To get that extra money to spend, government will have to issue more bonds.

Central bank will massively create new money to buy government bond, this process is known as Quantitative Easing (US). In a way the central bank is printing more money that will be used to buy government bond. Also, other countries can also fund the government by buying more of those bonds.

In running budget deficit, government will increase their spending to do more projects, such as public infrastructure upgrade; building new roads and freeways; expand rail network; public healthcare upgrade; build more schools and etc. All this activities and projects will encourage investment from companies, employment level will also start going up. And ultimately spur the economy into growth.

Risk of deficit

Inflation
In case you are wondering, yes the central bank can print money at will. However, massive printing of money will depreciate the value of the currency and create high inflation. If the central bank fails to manage it, high inflation will damage the economy.

Tax Increase
Running deficit might force the government to raise tax in future. Nobody likes tax increase. This will increase public dislikes against the government.

Unrealized Loss From Other Foreign Bond Holders
By having massive money supply, it will greatly depreciate the value of the currency. If foreign countries bond holders were to sell back those bonds or wait until maturity, they might suffer losses the moment they convert the money back to their own currency.

Undercut Private Investment

In the bond market, companies will have to compete with the government in selling bonds. Companies, to make their bonds more attractive to investors, will have to drive up the interest rate of those bonds. In the end, companies might find that it is not worth to sell those bonds with such high interest.

As a result, companies will not have enough funding, and started cutting down on investment on new projects.

Possible Unexpected Scenarios When Increase/Reduce Money Supply.

Although the main objective to control money supply is to either stimulate or cool down the economy. Sometimes things do not work as it supposed to be. Let’s explore various scenarios.

Scenario 1 – Country In Recession

With the country slipping into recession, central bank decided to reduce interest rate to stimulate the economy to encourage spending and investment. However, disaster strike, like a major earthquake; terrorist attack; or banks going into default for whatever reason. The public went into panic mode, rush to banks and do a massive withdrawal of money for emergency use.

In this case, the demand of money far outweighs the supply; the commercial banks will have to raise the interest rate to curb withdrawal. Despite the effort from the central bank, interest rate went up instead of down. In short term, prices of different classes of assets will likely reflect as below:

Asset Class Expected Reaction Likely Actual Reaction
Stock Market & Real Estate Up Down
Bond Prices Up Up
Bond Yield Down Down
Gold Up Down
Interest Rate (Federal Fund Rate) Down Up
Currency Down Up

In this scenario, increase of money supply by reducing the interest rate has failed to stimulate the economy.

Scenario 2 – Country with Loose Monetary Policy and Form Asset Bubble

With the economy is already doing very well, commercial banks are still able to lend out money at low interest rate, assets such as housing prices and stocks will appreciate to an unsustainable level and form asset bubble. The economy is overheating.

At the same time, inflation is creeping up. When the public begin to feel the pain of inflation, cut down spending and save money, and stop buying assets because they are too expensive. That’s when the bubble burst. Assets prices will start to fall as investors will start bidding down the prices to obtain cash.

Companies will start doing badly as business demand is slowing since everybody is saving cash due to inflation. Unemployment will start rising as companies begin to cut their expenses.

Commercial banks are making losses because people who took up the loan are not able to pay back the balance loan even after selling the assets, because the prices of asset have fallen. More and more people are getting bankrupt. Because of this, commercial banks will also curb lending as they are afraid of bad loans.

By then, there is little that central bank can do because monetary policy was already loose (low interest rate).

It gets worse, to improve business, companies will start to bring down prices on products and services, and economy will begin to experience deflation. With deflation, companies will have to do more job cuts to improve earnings. This brings unemployment rate even higher, bringing the economy into a downward spiral.

Scenario 3 – Sudden Increase of High Interest Rate and Slam the Overheat Economy

Let’s assume central bank realize the economy is overheating, and decide to cool it down. However, instead of increasing the interest rate slowly, the central bank hikes the interest rate at a rate that is so high that took everyone by surprise. This is like putting a jam brake on a sports car speeding on highway; the sports car can lose its control, flip and crash. Same things can happen to the economy.

When the money supply is reduced at such level which took everyone by surprise:

Business lending will drop dramatically due to high interest rate, and this slows down business investment. Less business investment mean lesser projects, and companies provide goods and services will begin to experience loses.

Currency will appreciate as there is lesser supply with the increase of interest rate. As the currency is appreciating, goods and services will appear to be more expensive to foreign countries; this will impact the export businesses of the country.

Unemployment will start rising as companies begin to cut spending to avoid losses.

Ultimately the jam brake brought down the economy to its knees.

How Central Bank Control Money Supply To Stimulate Or Cool Down The Economy?

I have talked about how high inflation will damage the economy of a country. Now let’s talk about what the central bank can do to control inflation. In the context of US central bank (Federal Reserve), there are three primary tools:

Deposit Banks’ Reserve Requirement

The central bank has the power to instruct banks to keep a certain threshold of money in the reserve, and it must not be lent out. This will force banks not to get into excessive lending.

By maintaining the reserve, the banks will have lesser money to lent out and circulate.

Discount Window (Discount Rate)

Commercial banks are able to borrow money directly from the central bank, at an interest date which is known as discount rate. Commercial banks will then lend out the borrowed money at an even higher interest rate to make profit.

In times of high inflation, central bank might bring up the discount rate, and commercial banks will tend not to borrow the money since it is more expensive.

So with lesser money lent out to the public, less money will be in circulation and money supply can potentially be reduced and slow down inflation.

Open Market Operations

Lastly, the leading mechanism used by the central bank to control the most widely talk about interest rate (you always see this in the news) – Federal Funds Rate, which is how commercial banks based on to charge one another for overnight lending.

Why would commercial banks want to lend to one another? Very often commercial banks have insufficient money to make new investment or lending, and they will have to resort to borrow money from other commercial banks.

Central bank cannot force all the banks to stick to the same interest rate, as this would make the banking sector very non-productive and banks will not develop competitiveness to one another. What it does is by setting a target interest rate, and then influences every bank to adopt the interest rate by buying financial assets such as government bonds, foreign currency, gold and etc.

Let say when central bank announced that it will target to bring down the interest rate. It buys government bonds from the bond market and brings up the prices of government bonds, and brings down the interest rate on bonds. Commercial banks will find the yield on government bonds unattractive, and started cashing out the money.

Commercial banks will start lending out the money at a cheaper interest rate since there is more supply after selling out the government bonds.

So, when the central bank wants to bring up the interest rate, it will start selling the government bonds, bring down the prices of bonds, and bring up the interest rate of bonds. Commercial banks will find that the yield on bonds is now more attractive to invest, and start to bring up interest rate to curb lending, and put more of their money into government bonds.

Impact Of High Inflation Caused By Massive Money Supply Or Oil Shock

I used to wonder why is it that all the central banks in the world are so afraid of high inflation, and why must they pay so much attention to it. Here’s why:

For a country to be prosperous, its real GDP must be growing consistently. As the country is growing, it will expect inflation, because there will be more demand for goods and services, as everybody has more money to spend. More spending and buying will lead to prices getting higher and higher. It should not be a worrying sign if inflation is controlled at a rate which is lower than the growth of GDP.

However, sometimes due to loose monetary policy, where there is a huge circulation of money supply, such as over lending by the banks, ultra low interest rate; or sudden increase of oil prices due to whatever reasons. The country will experience high inflation, which is a worrying sign.

Lose of Competitive Edge 

Imagine Country A and Country B are both achieving steady economic growth with double-digit GDP growth. However Country A is experiencing inflation at 5 percent, and 10 percent for Country B. Goods and services will appear to be cheaper from Country A as it is experiencing lower inflation.

Assuming that Country B is selling similar goods and services as Country A. Companies in Country B will start to lose their business, and begin job cuts. Ultimately it will leave Country B with high unemployment. Its GDP will contract and embroil in recession.

Country A Country B
Inflation → 5% Inflation → 10%
Goods and Services look cheap Goods and Services seem expensive
Country A is a happy man because it is able to sell more goods and services. Country B is in pain because companies are losing business.

Reduce Household Spending Power

Normally the wages of employees do not always rise as fast as inflation. Because all companies and bosses will definitely want to keep more cash as profit. Imagine if the economy is experiencing an annual inflation of 10 percent, where the annual average employee’s wage rises at a rate of 5 percent.

Household will have less spending power and start to save more money in the banks. Less spending will erode companies’ earnings that are selling goods and services, and eventually lead to high unemployment, and contract the GDP.