Quantitative Easing and the Fed 2008-2014: A Tutorial
1. Economics for your Classroom from
Ed Dolan’s Econ Blog
Quantitative Easing and the
Fed: 2008-2014
A Tutorial
Revised November 2014
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free
to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
2. Understanding Quantitative Easing
Central banks—the Federal
Reserve, the European Central
Bank, the People’s Bank of China,
and others—are among the most
powerful institutions in the world
One of their potentially most
powerful but least understood
instruments is Quantitative Easing
or QE, a type of policy that the Fed
pursued for six years, from late 2008
to late 2014
This tutorial explains the mechanics
of QE and its effects on the US
economy
Federal Reserve Building,
Washington, DC
Photo by Agnosticpreacherskid,
http://upload.wikimedia.org/wikipedia/commons/8/8d/Marriner_S._Eccle
s_Federal_Reserve_Board_Building.jpg
Revised version November 2014 Ed Dolan’s Econ Blog
4. The Central Bank Balance Sheet: Assets
Fig 1 gives a stylized balance sheet
of a typical central bank
Net domestic assets consist of all
assets denominated in the country’s
own currency, e.g., bonds issued by
its government, adjusted by
subtracting certain liabilities and
capital
Net foreign assets consist of all
assets denominated in foreign
currencies, e.g., bonds issued by
foreign governments, adjusted by
subtracting foreign liabilities, if any
Revised version November 2014 Ed Dolan’s Econ Blog
5. The Central Bank Balance Sheet: Liabilities
The sum of the items on the
liabilities side of the balance sheet is
called the monetary base, which
consists of two parts
Reserve deposits that private
commercial banks hold with the
central bank
Currency (paper money)
Revised version November 2014 Ed Dolan’s Econ Blog
6. The Central Bank and Commercial Banks
The central bank balance sheet is
linked to those of commercial banks
through reserves of liquid assets held
by commercial banks:
Reserves of currency used to fill ATM
machines and serve other needs
Reserve deposits in accounts that
commercial banks maintain with the
central bank
Loans to consumers and firms are
banks’ main income-earning assets
Bank deposits held by consumers and
business firms are banks largest
category of liabilities
Revised version November 2014 Ed Dolan’s Econ Blog
7. The Complete Financial System
We complete our stylized picture of the
financial system by adding the balance
sheet of the “nonfinancial public,”
consisting of all private firms except
commercial banks and all households
The public balance sheet is linked to the
central bank via currency—an asset of
the public and a liability of the central
bank
Bank deposits are an asset of the public
and a liability of commercial banks
Loans—an asset of commercial banks
and a liability of the public—are the last
important link among the balance sheets
Revised version November 2014 Ed Dolan’s Econ Blog
8. The Money Stock and the Equation of Exchange
The nation’s money stock or money
supply consists of the total value of
currency and bank deposits held by the
public. (Currency held by banks is not
included). The most common measure of
the money stock is known as M2
In practice, bank deposits form 80 to 90
percent of the money stock in the
monetary systems of developed
countries, and currency plays a minor
role
Revised version November 2014 Ed Dolan’s Econ Blog
9. Central Bank Open Market Operations
Open market operations are one of the
most important tools that central banks
use to control the money stock
These are purchases or sales of assets
(usually government securities) from or to
the public via secondary markets that are
open to all buyers and sellers—hence the
name “open market” operations.
Note: This and subsequent slides use “T-accounts,”
which are simplified balance
sheets that only show items that change
as a result of whatever operation we are
discussing
Revised version November 2014 Ed Dolan’s Econ Blog
10. Open Market Operations Step-by-Step
Step1: The central bank adds to its
holdings of domestic securities by buying
them from a bank
Step 2: In return, the central bank credits
an equal amount to the bank’s reserve
account
Step 3: The result is an increase in bank
reserves and in the monetary base
Revised version November 2014 Ed Dolan’s Econ Blog
11. Open Market Operations: Alternative Version
Step1a: Alternatively, the central bank
could buy the securities from dealers who
are not banks or from other members of
the public
Step 2a: The central bank pays for the
securities using a payment order that is
executed through the banking system.
Sellers of the securities receive payment
as deposits added to their bank accounts
Step 3a: To complete the payment
process, the central bank adds an equal
amount to the reserve deposit of the
commercial bank or banks where the
sellers keep their accounts
Revised version November 2014 Ed Dolan’s Econ Blog
12. Further effects of open market operations
The immediate effects of an open market
operation are increase in bank reserves
and the monetary base
Subsequently, banks may make new
loans to members of the nonfinancial
public
If they do so, the proceeds of the loans
are paid out to the borrowers in the form
of added bank deposits. The result is a
further expansion of the money supply
with no further change in reserves or the
monetary base
Revised version November 2014 Ed Dolan’s Econ Blog
13. The Costs of QE: Recycling Interest Payments
What, if anything, is the cost of QE to the
Fed? To the government as a whole?
When the Fed buys securities, interest it
collects is a source of income for the
Fed, but the Fed is not allowed to profit
from it.
After deducting its operating costs, it
turns any surplus back to the Treasury.
In the simplest case, where the securities
purchased are government bonds, QE is
purely a bookkeeping operation with no
immediate cost to the Fed or to the
government as a whole
The Fed
The
Treasury
Treasury photo by David Monack, http://commons.wikimedia.org/wiki/File:GallatinTreas.jpg
Revised version November 2014 Ed Dolan’s Econ Blog
16. Effects of Open Market Purchase: Traditional Textbook Version
According to a traditional textbook model,
open market operations affect the economy
through two key ratios:
The ratio of the M2 money supply to the
monetary base is known as the money
multiplier
The ratio of nominal GDP to the money
supply is known as the velocity of circulation
of money, or, for short, simply velocity
If the money multiplier and velocity were
fixed constants, then the Fed could control
the economy as easily as a child can control
a model train
Revised version November 2014 Ed Dolan’s Econ Blog
17. Before QE
The first massive purchases of
assets by the Fed, now known as
QE1, began in mid-2008
Before that time, the money
multiplier and velocity ratios in
reality been approximately constant,
as we can see from the fact that the
monetary base, the money stock,
and nominal GDP tracked closely
together.
Note: In this and the following
figures, the base, the money stock,
and GDP are all charted with their
values for Jan. 2008 = 100
Revised version November 2014 Ed Dolan’s Econ Blog
18. Effects of QE1
As soon as the Fed began the first
phase of QE, however, the
economy stopped behaving
according to the textbook model
The monetary base grew rapidly,
but the money stock grew only
slightly. The growing gap between
the curves indicates a rapidly falling
money multiplier
The money stock increased but
nominal GDP at first continued to
fall. The gap between the curves
indicates a decrease in velocity
Revised version November 2014 Ed Dolan’s Econ Blog
19. From QE1 to QE2
Because QE1 failed to get the
economy back on track, the Fed
decided to try again. From late 2010
to mid-2011, it carried out an
additional large scale purchase of
assets that became known as QE2
Nominal GDP did begin slowly to
increase, but the effects of QE2
were weak and the curves
continued to diverge
Revised version November 2014 Ed Dolan’s Econ Blog
20. Finally, QE3
In September 2012 the Fed decided
to begin a third round of easing, QE3
Unlike QE1 and QE2, QE3 had no
specified end date, but was intended
to continue until the economy
improved
As under QE1 and QE2, the curves
continued to diverge. There was no
mechanical linkage between
monetary policy and the economy as
a whole, but nominal GDP did
continue to grow and the economy
began slowly to improve
Revised version November 2014 Ed Dolan’s Econ Blog
21. Progress toward the Fed’s Targets
The Fed sets official targets of
2 percent for inflation and
5.25-5.75 percent for
unemployment
By late 2014, unemployment
had fallen to 5.9 percent. The
Fed decided that there had
been enough progress toward
the targets to bring QE3
officially to a close
Did QE work? Can the Fed
take credit for the recovery, or
would the economy have
recovered anyway?
Revised version November 2014 Ed Dolan’s Econ Blog
22. How QE may have worked
Supporters of QE say we should not expect it
to work through rigid ratios like the money
multiplier and velocity
One theory says that it works by changing
the relative amounts of long- and short-term
securities, thereby lowering long-term rates,
supporting stock prices, and encouraging
investment
Another theory says the most important
effect is forward guidance, that is, changing
people’s expectations about what the Fed will
do in the future
Jackson Hole, Wyoming
Source: Enricokamasa via
http://commons.wikimedia.org/wiki/File:Corbet
%27s_Couloir_jackson_hole.jpg
For a detailed discussion of how QE
works, see this paper by Michael
Woodford presented at the Fed’s 2012
conference in Jackson Hole, WY
Revised version November 2014 Ed Dolan’s Econ Blog
23. Monetary vs. Fiscal Policy
Supporters of QE place part of the
blame for a slow recovery on fiscal
policy, which is beyond the Fed’s
control
Despite some stimulus in 2008 and
2009, fiscal policy soon became tighter
as Congress cut spending to reduce the
federal deficit (see chart on next slide)
In the words of former Fed chairman
Ben Bernanke, “Monetary policy cannot
achieve by itself what a broader and
more balanced set of economic policies
might achieve.” (Speech of Aug 31, 2012)
Revised version November 2014 Ed Dolan’s Econ Blog
vs.
24. US Fiscal Policy, 2006-2014
The best single measure of the
stance of fiscal policy is the
primary structural balance
(PSB), which is the surplus or
deficit, excluding interest
payments, that would prevail if the
economy were at full employment
Fiscal policy moves adds stimulus
if the PSB decreases (down on the
chart) from year to year and
restraint if it increases (up)
After 2009, fiscal restraint offset
much of the monetary stimulus
from quantitative easing
(Follow this link for a more detailed discussion)
Revised version November 2014 Ed Dolan’s Econ Blog
25. The Bottom Line
The US experience with quantitative
easing shows that during a deep
recession, the central bank’s control
over the economy is weak. Trying to
stimulate the economy with monetary
policy alone is like “pushing a string.”
Tight fiscal policy further limited the
effectiveness of quantitative easing.
Nonetheless, it is likely that QE did
have a positive effect. Very likely the
recession would have been even
deeper and the recovery even slower
without it.
Revised version November 2014 Ed Dolan’s Econ Blog
26. For more slideshows and commentary, follow Ed Dolan’s Econ Blog
Like this slideshow?
Follow @DolanEcon on Twitter
Click here to learn more about Ed Dolan’s Econ texts