Quantitative Easing: A Tutorial

Free Slideshow from Ed Dolan’s Econ BlogQuantitative Easing: A Tutorial September 13, 2012 http://commons.wikimedia.org/wiki/File:QE2-South_Queensferry.jpg Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.

The Mystery of Quantitative Easing Central banks—the Federal Reserve, the European Central Bank, the People’s Bank of China, and others—are among the most powerful institutions in the world One of their potentially most powerful but least understood policy instruments is “Quantitative Easing,” or QE This tutorial attempts to explain the mechanics of QE and its effects to Federal Reserve Building, date on the US economy Washington, DC Photo by Agnosticpreacherskid, http://upload.wikimedia.org/wikipedia/commons/8/8d/Marriner_S._Eccle s_Federal_Reserve_Board_Building.jpg Posted Sept. 13, 2012 Ed Dolans Econ Blog

The Central Bank Balance Sheet: Assets Fig 1 gives a stylized balance sheet of a typical central bank Net domestic assets consist of all assets denominated in the country’s own currency, e.g., bonds issued by its government, adjusted by subtracting certain liabilities and capital Net foreign assets consist of all assets denominated in foreign currencies, e.g., bonds issued by foreign governments, adjusted by subtracting foreign liabilities, if any Posted Sept. 13, 2012 Ed Dolans Econ Blog

The Central Bank Balance Sheet: Liabilities The right-hand side of the balance sheet is simplified by moving capital and nonmonetary liabilities to the left-hand side and subtracting them from assets to give “net” assets, as explained on the previous slide The remaining monetary liabilities are called the monetary base, which consists of two parts  Reserve deposits that private commercial banks hold with the central bank  Currency (paper money and coins) Posted Sept. 13, 2012 Ed Dolans Econ Blog

The Central Bank and Commercial Banks The central bank balance sheet is linked to those of commercial banks through reserves of liquid assets held by commercial banks:  Reserves of currency used to fill ATM machines and serve other needs  Reserve deposits in accounts that commercial banks maintain with the central bank Loans to consumers and firms are banks’ main income-earning assets Bank deposits held by consumers and business firms are banks largest category of liabilities Posted Sept. 13, 2012 Ed Dolans Econ Blog

The Complete Financial System We complete our stylized picture of the financial system by adding the balance sheet of the “nonfinancial public,” consisting of all private firms except commercial banks and all households The public balance sheet is linked to the central bank via currency—an asset of the public and a liability of the central bank Bank deposits are an asset of the public and a liability of commercial banks Loans—an asset of commercial banks and a liability of the public—are the last important link among the balance sheets Posted Sept. 13, 2012 Ed Dolans Econ Blog

The Money Stock and the Equation of Exchange The nation’s money stock or money supply consists of the total value of currency and bank deposits held by the public. (Currency held by banks is not included) In practice, bank deposits form 80 to 90 percent of the money stock in the monetary systems of developed countries, and currency plays a minor role Posted Sept. 13, 2012 Ed Dolans Econ Blog

Central Bank Open Market Operations Open market operations are one of the most important tools that central banks use to control the money stock These are purchases or sales of assets (usually government securities) from or to the public via open secondary markets— hence the name “open market” operations.Note: This and subsequent slides use “T-accounts,” which are simplified balancesheets that only show items that changeas a result of whatever operation we arediscussing Posted Sept. 13, 2012 Ed Dolans Econ Blog

Open Market Operations Step-by-Step Step1: The central bank adds to its holdings of domestic securities by buying them from security dealers or other members of the public Step 2: The central bank pays for the securities using a payment order that is executed through the banking system. Sellers of the securities receive payment as deposits added to their bank accounts Step 3: To complete the payment process, the central bank adds an equal amount to the reserve deposit of the commercial bank or banks where the sellers keep their accounts Posted Sept. 13, 2012 Ed Dolans Econ Blog

Further effects of open market operations The first three steps in the open market operation result in an increase in bank reserves and a equal increase in the money stock, in the form of bank deposits To complete the story, banks use the added reserves as a basis for making new loans. The proceeds of the loans are paid out to the borrowers in the form of added bank deposits. The result is a further multiple expansion of the money supply beyond the immediate impact of the open market operation Posted Sept. 13, 2012 Ed Dolans Econ Blog

What is Quantitative Easing? In normal times, an increase in bank reserves pushes down market interest rates and encourages investment, so that even a relatively small open market operation can stimulate the economy However, when interest rates are near zero, as they have been during the crisis, very large purchases of assets may be needed to have any significant effect on the economy. Such very large central bank purchases of assets, including long-term as well as short-term securities, are known as quantitative easing (QE) Posted Sept. 13, 2012 Ed Dolans Econ Blog

Giving QE a Try Early in the crisis, the Fed undertook a large scale asset purchase program, now known as QE1, which resulted in a huge increase in the monetary base The money stock increased only slightly, because banks were reluctant to lend out all of their new liquid reserves Even though the money stock grew, the velocity of its circulation through the economy fell and nominal GDP continued to decrease. Posted Sept. 13, 2012 Ed Dolans Econ Blog

QE1 vs QE2 Because QE1 failed to get the economy back on track, from late 2010 to mid-2011, the Fed carried out an additional large scale purchase of assets that became known as QE2 The Fed estimates that QE1 and QE2 together lowered long-term interest rates by 0.8 to 1.2 percentage points It estimates that output is 3 percent higher than it otherwise would be and about 2 million jobs were created Posted Sept. 13, 2012 Ed Dolans Econ Blog

Now QE3 Although the Fed believes that QE1 and QE2 have improved economic performance relative to what it would have been, the recovery remains slow In September 2012 it decided to begin a new round of easing, QE3 QE3 will buy $40 billion per month of mortgage-backed securities, and will continue some other bond- buying programs Unlike QE1 and QE2, QE3 has no specified end date. It will continue until the economy improves by enough to justify its termination Posted Sept. 13, 2012 Ed Dolans Econ Blog

Recycling Interest Payments When the Fed buys securities, interest it The Fed collects is a source of income for the Fed, but the Fed is not allowed to profit from it. After deducting its operating costs, it turns any surplus back to the Treasury. Does that mean that QE has no cost, so that there is, after all, such a thing as a free lunch? In the short run, yes, but there are two important qualifications The Treasury Treasury photo by David Monack, http://commons.wikimedia.org/wiki/File:GallatinTreas.jpg Posted Sept. 13, 2012 Ed Dolans Econ Blog

Qualifications to the Free Lunch Theory of QE Qualification No 1: Since 2008, the Fed has begun paying interest on banks’ reserve deposits, so not all the interest is recycled. The “free lunch” is at best a lunch at a discount price Qualification No. 2: The Fed will not be able to hold its big QE purchases of bonds forever. Sooner or later, the economy will begin to recover. The Fed’s exit strategy from QE will require selling off most of the extra securities to prevent excess money growth and the Photo: © BrokenSphere / Wikimedia Commons risk of inflation. Under some conditions, it might even have to sell them at a loss Posted Sept. 13, 2012 Ed Dolans Econ Blog

The Bottom Line: Will QE Save the Economy There is substantial evidence that QE has made the economy somewhat better off than it would otherwise have been However, we also need responsible fiscal policy. In Fed Chairman Bernanke’s words  It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs.  Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve.Source of quotes: Speech of Aug 31,2012 Posted Sept. 13, 2012 Ed Dolans Econ Blog

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Quantitative Easing: A Tutorial

by Ed Dolan on Sep 13, 2012

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