0

The Central Bank of a large economy has decided to implement a Quantitative Tightening (QT) policy to reverse its decade-long policy of Quantitative Easing (QE). The Bank considers the economy to be growing at a moderate rate with close to full employment. (i) Discuss the likely impact of the QT policy on the following items, assuming a smooth transition to the new policy: (a) asset prices (b) wealth and economic inequality (c) economic growth (d) price inflation (e) wage inflation. [12] Domestic asset prices increased significantly during the period of QE. The Board of the Central Bank is concerned about whether the QT policy may give rise to a significant correction in these prices. Explain why there is a risk of a significant correction in domestic asset prices from the new policy. [11] A pension fund has a portfolio comprising 50% long-dated domestic bonds and 50% domestic equities. Its Investment Committee is concerned that the QT policy could lead to a significant correction in domestic asset prices and wants to protect the funding level against this. Suggest investment strategies that the Investment Committee could adopt. [5] As interest rates rise, it is suggested that banks are lending insufficient funds to small businesses and that risk-based capital requirements are reinforcing this behaviour. As a solution to this, a country's banking regulator has proposed requiring banks to hold a fixed amount of capital for all loans, irrespective of their risk level. (iv) Describe some of the positive and negative consequences of such a change. [7]