On thursday, the Bank of England announced another round of ‘quantitative easing’ amounting to a further £75bn of asset purchases. The Bank is hoping that this will boost economic activity by pushing down long-term interest rates thus boosting private sector investment.
Will it work? Well, let’s take a quick look at some data and see what has been happening so far. Below we have a graph of Net funds raised by UK businesses for the period January 2007 – August 2011, produced by the Bank of England.
We can see that since the end of 2008 the private sector has been choosing to pay down its debt rather than raise new funds for investment. Now let’s take a quick look at the effective interest rate on new lending to UK businesses taken from the Bank of England.
Here we see that rates dropped rapidly at the end of 2008 and have remained flat for the last 2 ½ years yet from the first graph we know that UK businesses are choosing not to expand investment. Interest rates certainly can't get much lower. What’s going on? Can there really be a drought of profitable investment projects at the moment when rates are this low?
Standard economics says that firms will continue to employ capital until the rate of return on capital matches the cost of capital (the rate of interest). So, another round of Quantitative Easing should lead to greater investment. But right now, firms are demand constrained because households are deleveraging, inflation has remained stubbornly high eroding households’ wealth and consumer confidence is low. In the extreme case firms can’t sell an additional unit of output. Thus, the rate of return on an additional unit of capital is zero while the previous unit may have a rate of return significantly greater than zero. See graph below for an illustration.
Standard economics says that firms will continue to employ capital until the rate of return on capital matches the cost of capital (the rate of interest). So, another round of Quantitative Easing should lead to greater investment. But right now, firms are demand constrained because households are deleveraging, inflation has remained stubbornly high eroding households’ wealth and consumer confidence is low. In the extreme case firms can’t sell an additional unit of output. Thus, the rate of return on an additional unit of capital is zero while the previous unit may have a rate of return significantly greater than zero. See graph below for an illustration.
Here we assume that capital has a diminishing marginal rate of return as shown by the downward sloping MPK curve. The MPK is zero for all levels of capital to the right of the dotted line. Equilibrium is where the current rate of interest meets MPK curve. Now, if the current interest rate falls to the blue line then there is no increase in the level of capital employed in the economy.
The effect is a private sector that is not willing to use the funds that the central bank is pumping in and consequently the normal mechanism by which monetary policy works is broken.
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