Quantitative easing is a form of monetary policy adopted by central banks in order to increase the money supply in the economy through money printing and open market operations, such as by buying treasury bills. The last 2 years have been financially harsh for the economies of the world, and notably the United States. During the financial crisis 2008, US President Barrack Obama implemented a $700 billion stimulus package in order to get the American economy "back on its feet". Two years later, the economy finds itself near the same situation, with Obama proposing another round quantitative easing worth $600 billion through treasury bills purchases.
Purpose of the policy
The Federal Bank published a press release [1] on the 3rd of November this year stating that the Federal Open Market Committee (FOMC) has voted for the purchase of an additional $600 billion worth of long-term treasury bills funded through electronic money printing. The explanation by the committee is that the outcome of the first quantitative easing hasn't met up with the expectations, noting that the unemployment rate persists to be very high, output growth remains slow and overall spending (both by household and firms) is still at disappointing levels, preventing the rate of inflation from adjusting itself to the rhythm of the economy (which remains quite low). See graphs below.
C:\Users\Phat\Documents\RHUL\Second Year\EC2202\Essay\Autumn Essay\Labor Force Statistics from the Current Population Survey.png
(Source: Bureau of Labour Statistics, www.bls.gov )
(Source: Trading Economics, www.tradingeconomics.org )
(Source: Trading Economics, www.tradingeconomics.org)
The expectations for the second round of quantitative easing is composed by mixed feelings, some pleeding success for the recovery of the American economy, while others believe that this will just worsen it, and possibly other economies as well.
Expected benefits
The first step of the quantitative easing is buying treasuries held by the public (households, firms and institutions) to an approximate worth of $75 billion each month. Through this action, money demand increases as interest rate simultaneously decreases.
If the theory holds, a monetary expansionary would decrease the interest rate due to a greater flow of money in the economy. This in turn, increases investment and overall level consumption, allowing households to borrow at lower costs and firms to find financial resources through more cost-efficient means. Thus by looking at the IS-LM model, we assume that the monetary policy doesn't affect the IS curve (the goods market), the monetary expansion causes the LM curve to shift to the right.
From here, we can describe the supposed effects on unemployment. Since output increases, likewise does employment and thus unemployment decreases, accompanied by an increase in nominal wages. The final result is an increase in the price level. If we look at the AS-AD model, the increase in nominal wages leads to an increase in the real money stock which increases output. This causes a rightward shift of the AD curve. Graphically we observe from this shift, an increase in the aggregate supply reflected by an increase in unemployment and an increase in output and price level.
Associated risks and possible outcomes
In the FOMC, voting member Thomas Hoenig was the only one out of 10 to vote against the policy, fearing that "continued high level of monetary accommodation […] over time, would cause an increase in long-term inflation expectations that could destabilize the economy" [2] . What we previously observed were the expected economic outcomes from the quantitative easing proposed by the Fed. However that is not the end of the story. That was the effect in the short-run, and in the medium and long-run, as Mr Hoenig fears, the outcomes might be perverted. As time goes, price expectations adjust to the price level and if the price level is higher than the expected prices, then people will readjust their expectations to the new level. If we plot this on the AS-AD diagram, we notice an increase in output and price in the short-run and return to original level of output in medium-run, however followed by a higher price level. The upward shift of the aggregate supply brings the economy back to its original level. So in the medium-run, monetary expansion has no great effect on output and merely induces inflation.
The threat of higher inflation is taken very seriously and is the QE2 opponents' main reason to object to its implementation. At a the national level, depending on the rate of inflation, the value of the Dollar could depreciate over time causing households and firms to hold less assets liquid, increased menu cost, higher prices for imported goods and uncertainty among firms (both local and international investors) in the investing climate. At the global level, the depreciation of the currency could be positive for American companies since their exports would then be cheaper on the global market. However, currency manipulation is not well seen by other nations and at a certain level of depreciation, people could lose their belief in the value of the currency which would be very bad for the US since the Dollar is renowned as the world reserve currency.
Conclusion - Quantitative Easing: the best solution?
In theory, the concept of quantitative easing is an ideal solution for economic recovery. However in the case of the United States, which is already heavily indebted (Total public debt outstanding $13.8 trillion) [3] and has a public deficit of $ 1.5 trillion [4] ; fuelling the economy with more money just after a recession might not be the best solution. There is a great risk for a liquidity trap if the expectations are low and people prefer to save their assets. This scenario would just accelerate the deflationary tendencies. Repeating what Mr Hoenig said in the press release: "the risks of additional securities purchases outweighed the benefits". It seems to me as a quite desperate (and risky) attempt to quickly escape from the current economic problems, while in fact the quantitative easing could just worsen the situation.
