The European Central Bank (ECB) is employing a new system of monetary policy which now it directly purchases government bonds from the Spanish and Italian governments. The objective is to lower interest rates on Spanish and Italian government bonds, which theoretically should show private investors that the two countries are financially able in returning their money thus decreasing the rising pressure on interest rates in the Eurozone, a dilemma threatening to counter the current torpid recovery from the 2008 and 2009 recessions.
Monetary policy is a term for the manipulation of the interest rates and money supply by the Central Bank of a country, managed to either decrease interest rates (expansionary monetary policy) or increase them (contractionary monetary policy). In hope of shifting the Eurozone economy closer to its full employment level, the European Central Bank currently is purchasing European government bonds proficiently boosting the money supply of the euro.
If effective, the ECB’s “quantitative easing” should reallocate loanable funds towards Spain and Italy’s private and public sectors as a result of lower interest rates on government bonds.
The increase in supply of loanable funds should bring down the interest rates for private investors (households and firms), making private investments more appealing.
The purchase of bonds by the European Central Bank makes it inexpensive for Spain and Italy to borrow money, lowering the interest rates on their bonds, returning international investor confidence, who may possibly be more agreeable in saving their money in Spain and Italian banks.
The influx of loanable funds into these economies (rise in the supply of loanable funds from to ) should decrease the real interest rate reassuring a greater number of firms to invest in capital goods and households to fund the consumption of a higher number of durable goods, pushing aggregate demand (AD) to the right (increase) returning the economy of the Eurozone to its full level of employment of output (represented as a shift from to in the right hand side graph).
Though usually monetary easing like this should result in inflation, it is unlikely given the European’s large gap in output (illustrated as the distance between and the full employment level of output shown as a dotted line). An increase in AD should result in an increase in output however insignificant inflation as a result of the excess capacity of the factors of production within the European economy.
An expansionary fiscal policy would prove impractical for Spain and Italy aiming for full employment as the increase in reluctance over their deficits and debts has triggered amassing borrowing charges from the private sector.
The ECB as Krugman debates should carry on playing a growing part in the development of credit to cash strapped European governments; with the intention of preserving low interest rates to prevent the crowding-out of private spending’s. The problem of inflation in Europe’s current recessionary atmosphere should be a rather miniscule concern. It is only when the confidence of private sector stakeholders has returned (a circumstance requiring small borrowing cost) will private sector spending recommence and the economies of the euro may begin generating employment and increasing their production again.
In the short-term, Italy and Spain should take profit from the ECB’s bond-buying initiative, and make significant, productivity-enhancing funding’s in infrastructure, schooling and job training. The states of the Eurozone must become more competitive with those of Eastern Europe and Asia if they optimise to economically grow.
In the medium-term, the Eurozone nations must exhibit a promise to fiscal limitation and more stable budgets. Eradicating loopholes that permit industries and prosperous consumers to evade paying taxes is imperative for example. In addition, rising the age of retirement, economizing on social welfare programs and raising marginal tax rates on the highest income earners should all visibly communicate the message to investors that these countries are indeed dedicated to fiscal restraint. As a result, their dependency on European Central Bank lending’s will deteriorate and private lenders will once more be keen on buying government bonds from the Eurozone at lower interest rates, permitting constant advancement in the private sector.