In 2008 the world faced one of the largest financial crises in recent times. This crisis was so deep and so hindering on growth in economies that the central banks of many countries resorted to using unconventional techniques to try and kick-start their economies where the traditional had failed them. The most prominent unconventional technique that they used is known as quantitative easing. In this essay I will explore and discuss the theory of how quantitative easing works and if it can be more effective than the traditional policy measures. To do this I will evaluate the usefulness of both the conventional and unconventional as monetary policy tools and explain which one of them achieves the objectives of macroeconomic policy the best.

The term quantitative easing (QE) refers to a certain technique that Central banks employ which entails the purchasing, through the electronic creation of money, of financial assets, such as mortgage backed securities, in order to indirectly lower long-run interest rates and hence boost consumption and investment and consequently improve the economy by boosting aggregate demand. This is opposed to the conventional expansionary monetary policy which is where the central bank prints extra money to carry out open market operations of purchasing short term government debt securities.

The supporting economic theory behind QE is as follows: the purchasing of large amounts of financial assets by the central bank should cause reserves in banks to gradually build up in quantity. This is because the central bank’s act of purchasing the financial assets is financed by the creation of more money. This additional money is then circulated around the economy and should next ideally then be loaned out from financial institutions to other economic agents. These lowered long-run interest rates should make it easier for firms and households to obtain loans.

Another explanation for this is that since the financial institutions would have received large sums from the central banks they would be looking to loan it out to borrowers and not need to take in more deposits for savers (the demand for reserves should fall.) Therefore the opportunity cost for them to keep their rates high would increase and this should influence them to lower their rates. Since this would be occurring across the economy, even financial institutions that did not sell any assets would have to lower their interest rates to remain competitive as potential borrowers would otherwise get loans from the other institutions with cheaper rates. The lower interest rates should lower the cost of borrowing for firms and households which should make them more likely to take loans in order to spend or invest. It also encourages potential savers to invest the money they would otherwise have saved in order to obtain higher returns, again boosting investment.

Due to the fact that many assets would have been purchased by the central bank their prices should rise and this should result in their yields falling which further incentivises people with money to invest in riskier ventures which may create more capital goods rather than in safer assets such as securities. As well as this the higher asset prices should create a wealth effect; as the values of their houses or shares go up they feel wealthier and are therefore more likely to feel financial stable and hence have a larger marginal propensity to spend, again increasing consumption.

Also when the supply of money is increased a hot potato effect is created. The hot potato effect in general occurs because an excess of a good is introduced into the economy and this disrupts the equilibrium. Before it was introduced people held as much of the good as they wanted at the existing price but the extra part then becomes the “hot potato” which people try to get rid of by selling it. So in this case the hot potatoes would be the extra money in circulation and when people try to get rid of this they spend it, thus raising consumption and investment. This notion is based on a theoretical idea that money almost has a mind of its own and will automatically flow around the world, in search of higher returns and therefore increases in money supply, caused by QE, will inevitably lead to a greater velocity of money and hence consumption and investment may increase. This idea, like most of economic theory, is flimsily based on the assumption that everyone acts rationally in order to allow the money to travel to highest returns, when in reality a lot of us make bad investments.

However this idea also reveals a great danger in stimulating the economy through increases in the money supply. This is the possibility that money may accumulate massively in certain groups of assets, where there is an exaggerated expectation of future growth, which causes their values to rise dramatically. This is known as a speculative bubble and has been seen several times across economic history, from the Mississippi bubble of 1718 to the US housing bubble of 2008. Once their values reach monumental highs they become much less appealing as an investment which leads to a decline in the rate of their increasing prices. This would then cause panic among investors who own some shares. When they see that the prices may start to decline their notions of accelerating future growth are quickly replaced by an objective analysis of the intrinsic value of the asset. At this point many will realise that its value is much lower than the market price which will cause a panic sell off and lead to a dramatic fall in price. This may in the worst cases lead to a financial meltdown or possibly even a revolution!

Using the Keynesian model (as shown above) of aggregate demand/supply we can clearly see that there are certain points where using quantitative easing would be much more beneficial. If the economy is undergoing a recession it would be very beneficial as it would help boost the anaemic aggregate demand to the intermediate range of the aggregate supply curve – providing growth with minimal inflation. However if the economy is already operating in the intermediate range it would most likely be counter-productive as it will lead to a very small increase the economy at the cost of incurring a lot of inflationary pressure. However this is dependent on to what extent the aggregate supply curve would be shifted out as if it is shifted out more than aggregate demand then there will be little inflation and high growth rates making the policy very effective even when in the intermediate stage. The extent to which the aggregate supply curve will shift depends on how much of the money created in the quantitative easing will actually be used to enhance the quality or quantity of factors of production. This is very hard to measure or estimate as the central banks cannot control what the firms spend their money on, however it is possible that they may have schemes to encourage certain spending. For instance they could set up a special economic zone where firms would be incentivised to build factories or offices (with promises of tax cuts).

Another transmission by which the quantitative easing program may influence a rise in the consumption and investment of the economy is through the expectations of future monetary policy. If the public see that the central bank has a quantitative easing program they may anticipate a rise in future real incomes due to the potential of future investment and subsequent creation of more jobs. These higher real incomes would mean lower real interest rates for given nominal rates. This is because the higher wages would lead to cost-push inflation which would in turn lower the real interest. The anticipation of a reduction in interest would cause some people to spend it. Over time as it becomes more and more apparent that the real incomes are rising and that real interest is falling more people will spend their money which would increase the investment and consumption.

The conventional monetary policy approach to the situations in which quantitative easing is deployed is known as expansionary monetary policy. When the expansionary monetary policy is deployed the central bank carries out open market operations and purchases short term government debt which increases the money in circulation by crediting banks’ reserve accounts. The increased inflow of money should then decrease the value of reserves as the banks would no longer want them as much and consequently create a rise in consumption and investment which should increase aggregate demand and also possibly the long run aggregate supply curve.

The two techniques differ in the nature of their purchases. For instance in conventional policy there are outright purchases of short term securities whilst in Quantitative Easing there are longer term debts with maturities of several years. Therefore it is intuitive that the duration of which conventional policy takes place is much smaller than QE. QE programs can last year’s whilst open market operations are conducted on a weekly and sometimes even daily basis. The implications of this are that QE may provide a greater sense of stability in assuring the longevity of changes in interest rates which may translate to banks being more willing to adjust their interest rates according to the QE program in the knowledge that their reserves are likely to replenish with the assurance of the central bank’s commitment to the QE program.

Another key difference between them is the ways in which they cause their desired outcomes. On one hand conventional monetary policy aims to carry out this task principally by adjusting the value of banks’ reserves when they purchase short term bonds. This is because they mainly aim to tweak the short-term interest rates of the economy to make reserves more or less sought after by banks. On the other hand in Quantitative easing the Central bank aims to control the quantities of reserves that the banks possess. They do this through the purchase of long term assets from private entities which raises the total quantity of reserves of the banking system.

Due to this key distinction, the efficacies of the two can change drastically with certain conditions. For example the efficacy of conventional monetary policy would drop drastically if they are unable to incentivise more lending through the reduction of interest rates. In other words it is not effective if the interest rates are close to or at zero it as going below zero would mean that potential lenders would actually end up losing interest on the money they would lend out which would clearly disincentives them from doing so having the opposite of the intended effect. This means that the efficacy of conventional policy drops rapidly as the economy approaches the zero interest rate which is effectively a lower bound. Therefore in these circumstances it is necessary for central banks to use quantitative easing rather than conventional policy as they would only be able to influence the level of borrowing in the economy through increasing the quantity of reserves rather than decreasing the values of the reserves as by traditional operations (which would create a situation of negative interest.)

As well as this, the distinction allows governments to choose what assets they want to buy which could be more beneficial than traditional policy. For instance governments may choose to buy a lot of mortgage-backed securities in order to not only stimulate the economy by lowering the interest rates but also to reduce mortgage rates. Which would have a knock-on effect of increased consumption as people would have a greater amount of disposable income. However in evaluating this point I came across a paper from Johannes Stroebel and John B. Taylor of Stanford University which discussed this issue and concluded that the relationship is weak and that the purchasing of mortgage-backed securities has hardly made an impact on the mortgage rates.

On the other hand, quantitative easing is arguably not very effective as there is a valid hypothesis that the flood of cash into the economy may cause reckless financial behaviour which could mirror the very situation before the 2008 which culminated in the financial crisis. This is because it can lead to widespread aggressive lending by banks, with large reserves, which could lead to a speculative bubble which can create a possible systemic crash when it bursts. Therefore as a precaution we should avoid pouring in excessive amounts of money into the program as this may cause banks to feel over confident and invest money into ventures that are very risky which may make them bite off more than they can chew. As well as this there is a concern for the long-term as eventually the central bank will have to sell off the assets that it bought and many people fear that this will lead to a soaring interest rate meaning that the practice is not very sustainable. To counter this in practice the quantitative easing process should be broken down into several stages which ease the selling off of assets over periods of time.

In conclusion central banks face a really big dilemma on whether or not they should use quantitative easing as it can be a huge gamble with the capacity to compromise the long-term sustainability of interest rates and even encourage the reckless behavior that could create speculative bubbles which are what crises are made from. I therefore believe that quantitative easing should be avoided as much as possible and hence should only be used in dire circumstances when the economy is in a severely suffering and interest rates are approaching zero so the alternatives will fail to achieve their aims. Under these circumstances quantitative easing can be justified as in recession’s people have tendencies to be more cautious with their money and hence it is less likely that reckless spending will be made. As well as this, in these circumstances the traditional policy alternatives effectively become nugatory (with the prospect of going into uncharted negative interest rates) so central banks have very few alternatives other than no intervention at all. Whilst this option may delight classical economists, in today’s world of elections, campaigns and politicians with increasingly too-good-to-be-true promises; not taking action is hardly an option.

Dylan Parekh