Question

1. what do you think is the goal of quantitative easing? What is the tradeoff that arises when a central bank raises money supply after a negative real shock?

Answer 1

Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to increase the money supply and encourage lending and investment. When short-term interest rates are at or approaching zero, normal open market operations, which target interest rates, are no longer effective, so instead a central bank can target specified amounts of assets to purchase. Quantitative easing increases the money supply by purchasing assets with newly created bank reserves in order to provide banks with more liquidity.

To execute quantitative easing, central banks increase the supply of money by buying government bonds and other securities. Increasing the supply of money is similar to increasing supply of any other asset – it lowers the cost of money. A lower cost of money means interest rates are lower and banks can lend with easier terms. This strategy is used when interest rates approach zero, at which point central banks have fewer tools to influence economic growth. If quantitative easing itself loses effectiveness, fiscal policy (government spending) may be used to further expand the money supply. In effect, quantitative easing can even blur the line between monetary and fiscal policy, if the assets purchased consist of long term government bonds that are being issued to finance counter-cyclical deficit spending.

The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand.

Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system.

The CB can look at the path of inflation/unemployment. A positive aggregate demand shock will trigger an increase in employment and in inflation, while a positive aggregate supply shock will trigger a fall in inflation. Using the 3-equation model, only aggregate demand shocks lead to immediate changes in output. Inflation or supply shocks lead to changes in inflation but not in output until the CB responds. This helps to distinguish between, for example, a negative aggregate demand shock and a positive supply shock: in both cases inflation falls but only in the first does output change, in this case, it falls. From the data on inflation and output it will be difficult for the CB to distinguish between a temporary and a permanent aggregate demand shock. It will need to make use of other indicators. Similarly it will be difficult to distinguish between an inflation shock and a supply shock initially.

The main difference is that while a negative supply shock will rise the ERU the aggregate demand shock does not. Therefore in the case of the supply shock the CB has to change its MR to be consistent with the new lower equilibrium value of output; diagrammatically, the MR line shifts to the left. After the shock inflation raises and therefore the CB has to increase the interest rate in order to achieve its inflation target. In the case of an aggregate demand shock activity will be depressed and inflation will fall, therefore the CB has to lower interest rates in order the expand demand and return to the inflation target.