What is Quantitative Easing?

Quantitative easing involves an increase in the quantity of money. There are different ways to define and measure the quantity of money, and so that leaves quantitative easing a bit vague. Since the Federal Reserve has promised to purchase $600 billion of government bonds over the next few months, the quantity being directly increased is the monetary base--currency held by the public and reserve balances banks keep at the Fed.

When the Fed creates base money, it directly increases the reserve balances that banks keep at the Fed--reserves. The Fed purchases the bonds, and pays for them by increasing the reserve balance of some bank. Further, the Fed purchases bonds directly from a limited set of primary dealers, all of which are large financial institutions, and many of which have commercial bank divisions that keep reserve balances at the Fed.

Given these institutional realities, one might see this quantitative easing as a policy that aims to buy $600 billion worth of government bonds from banks, so that the banks will now have less government bonds and more reserves. The question, then, is what will the banks do with these additional reserves. Will they make new loans to households and small business?

This perspective is mistaken. While it is true that the Fed directly increases bank reserves when it adds to the monetary base, the monetary base is made up of both currency and bank reserves. Withdrawals of currency by households and firms other than banks from their deposit accounts at banks would reduce the reserves of the banks, increase currency holdings, and leave the total monetary base unchanged.

More importantly, the primary dealers from whom the Fed directly purchases government bonds are middlemen. They are purchasing government bonds from other banks, firms other than banks, and households, in order to sell to the Fed. Any impact of quantitative easing on the transactions accounts (checking accounts) of those primary dealers that are not commercial banks or the reserve balances of those primary dealers that are banks are transitory. To the degree that those from whom the primary dealers buy are banks, then they have shifted from holding government bonds to reserve balances. To the degree that those from whom the primary dealers buy are not banks--are commercial and industrial firms or households--the quantitative easing raises the balances in their transactions accounts. In other words, households and firms selling the bonds have more money in their checking accounts.

So, quantiative easing also directly increases the quantity of money held by members of the nonbanking public--households and firms other than banks. To the degree that banks use their additional reserves to make loans, including purchasing other bonds (presumably other than the ones they sold directly to the primary dealers and indirectly to the Fed,) then those selling to those who received the loans, or those who sold the bonds, will also have larger transactions balances.

This is the conventional "money multiplier" process, that allows a given increase in base money created by the Fed to be multiplied. While it is possible to look at this by considering how much new money will be available for households and firms to hold given the amount of bonds purchased by the Fed, a better way to think about it is to see it as impacting the amount of bonds the Fed must purchase to get the desired increase in the quantity of money in the hands of firms and households.

Why would the Fed want to increase the quantity of money in the hands of the public? In order for households and firms to spend more of that money on consumer goods and capital goods in the near future. So, one important issue is whether or not households and firms who receive new money by selling bonds to the Fed or banks, or perhaps obtain loans from banks, will spend some or all of that money on consumer goods or capital goods.

If the banks don't increase loans, and households and firms will spend none of the money they receive from selling bonds on consumer goods or capital goods, and instead just leave that money in their transactions accounts, then quantitative easing will not have the desired effect. If, on the other hand, banks lend even a bit more of their additional reserves to households or firms who presumably will spend the borrowed funds on consumer or capital goods, and/or the households and firms spend even a bit of the money received from selling bonds on consumer goods or capital goods, then quantitaitve easing has had its desired effect at least to some degree.

It is possible to take a given amount of bond purchases by the Fed, and then try to determine how much will be held by banks as added reserve balances or else lent or used to purchase bonds, and so, how much the quantity of money will rise, and then, consider how much of that new money, when received by households and firms, will be spent on consumer goods and capital goods. However, a better perspective is to turn that around. What is the appropriate increase in spending on consumer goods and capital goods? How much does the quantity of money need to increase so whatever the part that is spent would be the needed amount? How many bonds must the Fed buy in order to increase the quantity of money that needed amount?

One way to look at this is to estimate what will be the income velocity of money. The needed change in spending on goods and services divided by the estimate for the income velocity of money is the needed change in the quantity of money. Then, it is necessary to estimate the money multiplier. The needed change in the quantity of money divided by the estimate of the money multiplier determines the needed change in base money. And that is how many bonds the Fed needs to buy.

Now, what is the reason to get households and firms to spend more on consumer goods and capital goods? This increase in spending will result in firms selling more. If firms can sell more, and they have the needed capacity, they will produce more. Real output, real income, and employment will all increase.

Of course, if the firms are already selling at a rate that matches their productive capacity, then the increase in spending will still occur. Firms would still like to produce more. But because they don't have the needed machinery, workers, and raw materials, they will not be able to produce more. Still, they will be able to make more money by raising prices. And they will be willing to offer to pay more for the limited amounts of resources, machinery, raw materials, and labor. And so, resources prices, including wages for the right kinds of labor, will also rise. In other words, the quantitative easing will lead to inflation.

So, this second problem with quantitative easing is not that it will have no effect. It is rather that the desired effect--increased spending--will have little or no desirable consequences. There will be at most a minimal increase in production and employment and instead simply be more inflation.

Of course, we know that spending in the economy fell approximately 13 percent below its trend growth path of the Great Moderation. The most signicant problem that firms face is not bottlenecks in productive capacity, but weak sales. Increased spending, will solve that problem. Will production and employent rise the level of the Great Moderation? No, productive capacity has been depressed. But the least bad response to depressed productive capacity is a higher price level, which does imply a temporary increase in inflation.

The Fed's proposal to purchase government bonds is a change in the right direction. Spending is too low, which implies the quantity of money is too low, which implies that base money is too low. Of course, the Fed should reduce the interest paid on reserves to slightly less than zero. And, most importantly, the Fed should commit to a target for slow steady growth of money expenditures.