Money: The Root of All SolutionsHow Quantitative Easing Pull The Economy Out of the Great Recession

By Christopher Shanley

Introduction

One of the FED’s main purposes is to ensure the constant well

being of the economy. They accomplish this by maintaining the

overnight interbank lending rate, which is used to ensure that all banks

have their required amount of deposits on reserve at the end of the

day. This overnight interbank lending rate is known as the Federal

Funds Rate. To ensure the economy stays in a constant state the FED

can manipulate this rate.1 They do this by increasing or decreasing the

amount of cash supply in the economy by means of purchasing or

selling securities, usually low risk short term treasury bonds.

In economic crisis banks supply of cash dwindles and the

demand for cash skyrockets, so the Federal Fund Rate increases

because money is scarce. The banks loose the ability to serve its

customers needs because they need the money to be kept on reserve

and cannot lend it out to its customers. To solve this problem the FED

buys short-term low risk securities to increase the money supply while

lowering the demand for money. This will effectively lower the Federal

Funds Rate and the economy should recover. But what if it doesn’t?1 This serves as bases of economic regulation in US economy and is not always accurate.

Throughout the past seven years the Federal Reserve (FED) has

initiated a program of quantitative easing (QE) which directly infuses

money into certain areas of the economy. The goal of this process is to

increase the supply of cash in these struggling sectors of the economy

to lower the long-term interest rate. In doing this demand for

investment in this sectors will increase, which will increase the overall

well being of the economy. This paper will be used to describe the

processes of the FEDs recent QE programs in comparison to other

similar programs used globally. Then it will discuss the impact of the

programs on the present economy’s health and discuss speculations of

the future impacts of the economy in relations to these programs.

When the FED lowered the Federal Funds Rates from 5% to

nearly 0% in 2008 the crisis in theory should have been solved, but it

didn’t. The factors that caused this crisis we based on the creation of

mortgaged backed securities and subprime mortgage loan defaults.

The creation of mortgaged backed securities (MBS) fed the demand for

more mortgages, which in turn relaxed regulations on subprime

lending. Subprime borrowers were now able to get mortgages on loans

that under previous circumstances they could not. In 2006 the housing

credit bubble burst when many of these subprime borrower could not

make the payments and defaulted on their loans. This cause the

eventual collapse of MBS market threw the US economy like many

others into turmoil. As stated before the FED lowered the Federal

Funds Rate to an all time low and there was no improvement. Many

central banks around the world had to turn to unconventional means to

stimulate the economy.

Unconventional Stimuli: Quantitative Easing

In this section we will discuss the different forms of quantitative

easing (QE) used in the US by the FED and other centralized banks

around the world.

QE is the process of buying unconventional securities for two

reasons. (1) To supply more money into the economy, (2) to liquated

certain struggling markets. In late 2008 and early 2009 that is exactly

what the FED did. They increased the money supply of the US

economy by 1.775 trillion purchasing assets like MBS, government

sponsored enterprise debt and long-term treasury bonds. Similar, the

Bank of England in the same period of time launch an asset purchasing

program of their own to help stabilizes their economy. While European

Central Bank and Bank of Japan had QE programs in place at the same

time, their programs focused around directly lending money to banks.

The first QE program used by the FED uniquely isolated certain

struggling areas of the economy (e.g. mortgaged backed securities

market, government sponsored enterprise, as well as banks).

Krishnamurthy and Vissing-Jorgensen (2011) state, “For riskier bonds

such as lower grade corporate bonds and MBS, QE1 had affects

through a reduction in default risk/default risk premia and a reduced

prepayment risk premium”. It also lowered yields on low risk long-term

bonds. The FED purchased these bonds by issuing reserve, increasing

the monetary base by 29%2. One of the major accomplishments of this

the first QE program was on the receiving side of the stimulus. Banks

voluntary held the excess supply cash in reserve deposits instead of

using it to lend out to customers. This provided the economy with the

necessary time to react properly to the stimulus.

In the process of the first QE program we can notice many

economic factors. First the quantity equation from the quantity theory

of money was not effect. While the monetary base did rise 29%, mostly

all other money supply factors stayed relative to constant growth. The

reasons I concluded was by looking at the M1, M2, and currency in

circulation growth from November 1, 2008 to November 1, 2009 in

comparison to monetary base growth for the same period. The only

inference I could conclude was that while the supply of money had

risen banks did not use the excess supply, this kept M2 relatively

growth normal. My findings can be found in Table 1.

The second QE came in late 2010 with a new purpose behind it.

Unlike the first QE program the second program was designed to

increase the still stagnate economy. This program, usually called

2 This information was created by myself using data from Federal Reserve

“QE2,” was explicitly designed to lower long-term real interest rates

and increase the inflation rate to levels deemed more consistent with

the Fed’s mandate from Congress (Fawley and Neely 2013).

Understanding rational expectations, when the FED announced the

second QE program would take affect in the future, inflation and bond

yields already adapted to the new monetary policy. This meant the

overall effectiveness of the program was not as efficient as the first

program when it came yield shift but as Figure 1 shows inflation rose

nearly two percent in the first half of 2011. Inflation was the key

importance in this second QE program; Chairman Bernanke understood

that in fundamental economics constant inflation growth translates to

growth of GDP.

The importance of this program is shown by later data because

this program was put in place to satisfy short-term needs in the

economy. As described by the effects of the Phillips Curve, once people

adapt and adjust to their expectations of inflation, unemployment will

adjust to the natural rate it was and inflation will readjust to the

unemployment rate. This caused expectations of another recession in

the late summer of 2011. The FED reacted to these spikes by setting

up a new program to inverse the long-term bond rates relative to the

short-term rates. The program was nicknamed “Operation Twist”

because the Fed sold $400 billion in short-term assets while purchasing

$400 billion in long-term assets (Fawley and Neely 2013).

Along with “Operation Twist” the FED implemented the now final

program of QE that was created to purchase $40 billion in MBS and

$45 billion in long-term treasuries a month. This program finished last

month. The effects of this last program have not seen substantially

impact on the economy at this point.

Aftermath of Quantitative Easing

In review of the last section the Fed and similar central banks

from the largest economies all went into a major recession in 2008. At

the end of 2014 we can see that most of these economies in the short

run have recovered. The US monetary base increase by more the four

times the size, unemployment is at 5.8%, and inflation is at 1.66%.

Understanding these factors, this section will provide speculative

forecasting for short run and long run effects the quantitative easing

programs will have on the future economy using my understanding

economic principle and theories.

First, from understanding the IS function on the IS-LM curve we

should expect GDP to rise in the next year. This is because the real

interest rates are expected to relatively low. When interest rates

remain low, planned expenditures will rise, which in total raises GDP.

Katherine Rushton (2014) reported, “businesses are making more

“fixed” investments in things like acquisitions and buildings.”

Statements like this show that the programs in the short run have

major benefits to short-term growth.

On the LM side of the curve we have the effects of money supply

on GDP. The FED throughout the past 7 years has injected the

economy with huge stimuli that have helped the economy sustain

growth. In understanding the LM curve we can see that the rise in

money stock over the CPI makes the interest rates fall and increase in

output. This brings us to an interesting point; the FED continually

shocked the system with an influx of money, this created the

environment where interest rates fall, planned expenditures increase,

and overall GDP rises. This all seems like positive growth but as

expectations adjusts in the future without QE will everything remain

constant or will be similar to the recession the US economy was just in.

This is an excerpt from The Telegraph on recent activity in the

stock market since the end of the QE programs.

However, US markets remain vulnerable. Earlier this month, the

S&P 500 erased its gains for the year amid fears over weakening

economic growth in Europe and Asia. The Dow Jones Industrial

Average came close to doing the same, as it dropped more than

400 points, or 3pc, in a single day. (Rushton, 2014)

The article goes on to state that the recovery of the market was

because of the FED hinting towards a fourth program. This shows that

the economy has adjusted to expect the Federal Reserve to use its

resources to keep the economy out of a recession.

My speculative long term forecast for the economy post QE

programs is that the economy needs time to adjust. The expectations

of the effects on the previous programs have not been in place for the

proper length of time to make accurate forecasting predictions.

Quantitative Easing is very difficult to comprehend, the policymakers

that put these plan into affect still don’t fully understand the

complexity of the programs. As we grow with the decision we made we

will learn the benefits and costs of the programs in the future. Then we

can make more accurate decisions.

As the Lucas Critique states “it is naive to try to predict the effects

of a change in economic policy entirely on the basis of relationships

observed in historical data, especially highly aggregated historical

data.” We can use this information we receive from the effects of QE

as base point in understanding how to solve the next crisis or

recession. To simply copy the same program in the future will not

guarantee the same success. What need to be learned is how these

policies will affect the expectations by monitor the behavior of the

people more then the numbers.

Figure 1

Table 1

Reference

Rushton, K. (2014, October 29). Federal Reserve ends QE. Retrieved December 6, 2014.

Fawley, B. W., & Neely, C. J. (2013). Four stories of quantitative easing. Review - Federal Reserve Bank of St.Louis, 95(1), 51-88. Retrieved from http://search.proquest.com.ezproxylocal.library.nova.edu/docview/1271598640?accountid=6579

Krishnamurthy, A., Vissing-Jorgensen, A., Gilchrist, S., & Philippon, T. (2011). The effects of quantitative easing on interest rates: Channels and implications for Policy/Comments and discussion. Brookings Papers on Economic Activity, , 215-287. Retrieved from http://search.proquest.com.ezproxylocal.library.nova.edu/docview/1020892977?accountid=6579