What Does Quantitative Easing Do?

by Elaine Schwartz    •    Sep 26, 2010    •    290 Views

A quantitative easing limerick:

“I’m afraid,” said Bernanke to Geithner,

“The debt crisis still has lots of bite in ‘er.

Though it may cause some ranklin’

I’ll print lots more Franklins;

We’ll loosen our money, not tighten ‘er!”

Alternatively…

When the Fed said “The Committee…is prepared to provide additional accommodation if needed to support the economic recovery and return to inflation…,” Slate’s Plain English Tool said they really meant to say, “We’ll keep an eye on things, and if we need to create trillions more dollars out of thin air to bring down unemployment and pump up inflation, that’s what we’ll do…”

The Economic Lesson

The standard story in econ textbooks says that when the Federal Reserve buys treasury securities or other financial instruments (quantitative easing), its goal is to expand the money supply through the money multiplier. Specifically, the Fed buys securities, the money is deposited in banks, reserves increase, more money is available for loans, interest rates fall, and borrowing accelerates.

But maybe, the standard textbook story is wrong. According to a recent Federal Reserve paper and a speech from a Fed vice chairman, “Bank loans are primarily driven by demand factors. If there is an increase in demand for loans, banks increase their supply of loans…and obtain the funding by issuing uninsured deposits.”(p. 39 from the Fed paper)

In other words, the key to activating the money multipier could be the demand for money rather than the supply of money. There might sometimes be a correlation between the Fed’s security purchases (quantitative easing) and the money multiplier but not necessarily causation.

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