This document provides a primer on monetary policy, the role of central banks like the Federal Reserve, and quantitative easing (QE). It explains that central banks were created to address problems with the gold standard like bank panics. The Fed aims to act as a lender of last resort and conduct monetary policy. QE involves the Fed buying bonds to lower long-term interest rates when short-term rates hit zero. While QE increases the money supply, it does not necessarily cause inflation if the money is not lent and spent. QE seems to be helping reduce unemployment, though it has risks like encouraging risk-taking that require oversight.

1. Monetary policy, the Fed & QE
A primer
Remarks by Greg Ip
U.S. Economics Editor, The Economist
To the Capital Markets Initiative
sponsored by Third Way

2. Why do we have money?
• It’s a store of value (examples of
things that act as store of value:
property, stocks, bonds, gold)
• It’s a unit of exchange (examples of
things that act as units of exchange:
wampum, gold coins, frequent flyer
miles, bitcoin

3. The BCB era
(before central banks)
• Money either consisted of coins made
from specie (gold & silver) or
banknotes convertible on demand to
specie – a gold or silver standard

4. How the gold standard worked
A bank, in normal times
Liabilities Assets
$9 notes or $9 of loans
deposits
$1 shareholder $1 of gold
equity
$10 total $10 total

5. That same bank, boom times
Liabilities Assets
$13 notes or $13 of loans
deposits
$1 shareholder $1 of gold
equity
$14 total $14 total
Credit, money supply expand
40%, result: inflation

6. The problem with gold standard
• If only a few people convert their deposits to gold, no
problem.
• If many people want to convert their deposits to gold, big
problem – not enough gold to go around
• Banks call in loans, stop repaying people their gold
• Everyone rushes to get their gold back. Result: panic!
And bank failures
• Bank panics in 1797, 1811, 1813, 1816, 1819, 1825,
1837, 1847, 1857, 1873, 1884, 1893, 1907

7. Bust
Liabilities Assets
$7 notes or $8 of loans
deposits
$1 shareholder $0 of gold
equity
$8 total $8 total
Credit, money supply shrink
40%, result: deflation

8. Solution: a central bank
• In 1913, Congress creates Federal Reserve to
supply an “elastic currency”
• When banks run short of cash, they can borrow
from the Fed
• The Fed “prints” money, lends it to banks, in
exchange for collateral,
• Later, banks repay the loans, the money is
withdrawn from circulation

9. The Fed’s two roles
• #1 Lender of last resort: to lend to solvent
banks that are temporarily short of cash, to
prevent panics and unnecessary failures.
• Problem: hard to tell when a bank is actually
solvent. Result: Depression
• #2 Monetary policy: regulate the overall supply
of credit to prevent recessions and control
inflation
• Problem: hard to know when the economy is
growing too fast or when inflation is going to rear
up. Result: 1970s

10. What causes inflation?
• Monetarist view:
• Fed prints money => too much money, too few goods =>
inflation
• Wrong! Fed doesn’t control all the money supply: only a
tiny bit, just enough to control the “Fed funds rate”
• Modern view of inflation:
• Fed keeps interest rate low => more spending, less
saving => spending exceeds economy’s ability to supply
goods => inflation
• If people expect higher inflation, they will set prices and
wages accordingly and it will be a self-fulfilling prophesy
• This is how ALL central banks view inflation nowadays

11. What causes unemployment?
• In the long run, supply: the structure of the
economy: demographics, labour market rules,
skills/technological change
• In the short run, demand. If spending rises but
does not exceed the economy’s supply, more
people will get jobs, unemployment will go down
• In spending rises and exceeds the economy’s
supply, only a few more people will get jobs; the rest
will get higher wages, and inflation will result

12. Conventional monetary policy
• If demand is falling and unemployment is rising, the Fed
lowers the short-term interest rate
• This also lowers bond yields as investors adjust to
expectations of lower rates for a while
• Result: more borrowing, spending, less saving, higher
employment
• Other effects: higher stock prices => wealth effect =>
more spending, investment
• lower dollar => more exports

13. Unconventional monetary policy
• Economy in really bad shape, people respond less to
lower interest rate because they can’t qualify for loans or
want to rebuild savings
• Result: short-term rate falls to zero and stillnot enough to
get spending up, unemployment down
• Solution: reduce long-term rates. How?
• Words: Fed says it will keep short-term rate lower
(affects bonds yields)
• Actions: Fed buys bonds, directly lowering bond yields
• How does it pay for bonds? By selling treasury bills
(“Operation Twist”)
• Or by printing money (“quantitative easing”)

14. Does QE cause inflation?
Printing money causes inflation only if the money
is lent & spent …
7.90 Money supply 3.0
(right axis)
7.70 2.5
7.50
2.0
7.30
$trn
1.5
7.10
1.0
6.90
Bank credit 0.5
6.70
(left axis)
6.50 0.0
2008 2009 2010 2011 2012

15. … or if expected inflation rises
3.5
3.0 Expected inflation
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Real bond yield
-1.0
-1.5
2008 2009 2010 2011 2012

16. Does QE reduce unemployment?
• It should, with these caveats:
• Buying Treasury bonds may reduce the cost of
borrowing for the government, but not necessarily
for corporations and homeowners
• When corporations’ bonds yields decline, they may
simply refinance debt, buy back stock, not invest
• Directly reducing mortgage yields by buying
mortgage securities directly helps homebuyers
• But many homebuyers can’t qualify for a new
mortgage

17. A lot of QE benefit swallowed up
Gap between mortgage rate paid by homeowner,
and yield on mortgage bond
Source: http://www.newyorkfed.org/research/conference/2012/mortgage/primsecsprd_frbny.pdf

18. But seems to be working
Housing starts, homebuilder sentiment

19. What could go wrong?
• Sustained low yields could produce more risk taking,
bubbles
• Solution: better regulation
• It may be hard for the Fed to undo QE, and thus
control inflation
• Solution: raise short-term interest rates
• Reduces pressure on President, Congress to reduce
the deficit
• Solution: How about a fiscal cliff?

20. Shameless self promotion
• Thinking citizen’s guide to the
economy
• Clearly written, examples,
anecdotes
• No Greek letters or charts.
• Not a crisis book
• Does explain origins of crisis,
and its consequences
• Journalism, not ideology
• Useful: explains economic
indicators and economic
concepts
• Little: half the size of most hard
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21. Thanks for listening
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