Easing in Early November 2010  Research Paper

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The timing of the quantitative easing is therefore essential. The first round of QE in 2009 essentially served the purpose of stabilizing the economy; the second round is intended to sustain the ongoing economic recovery by providing sufficient capital in the system that the positive momentum generated in the economy will eventually become a feedback loop of its own that results in the restoration of GDP growth and a reduction in the unemployment rate.

To analyze the effectiveness of this strategy, the case of Japan can be analyzed. The Bank of Japan's QE policy, which was aggressive in nature, resulted in creating strong liquidity in the Japanese economy. Market expectations of inflation were impacted as well. However, the Japanese experience did not result in improving job creation. In these Japanese experience, the stimulative effects of quantitative easing did not extend beyond the stabilization of the financial sector, "suggesting that the transmission channel between the financial and non-financial sectors had been blocked" (Shiratsuka, 2010). In the United States the most recent round of QE, which is ongoing, is timed at a point when recovery has already been stimulated by fiscal policy, with the objective of maintaining momentum that already exists. The Japanese experience did not have this momentum, so the impacts of the QE were less successful at addressing the nation's unemployment rate. The Japanese experience tells us that the timing of the QE is important, because there needs to be efficient flow of capital through the intermediaries into the economy in order for the policy to create jobs.

Export Costs

One of the most important impacts of a quantitative easing program is the effect that it has on the value of the currency. By increasing the supply of money in the economy, the currency is effectively devalued. This strategy works in particular when the business cycles of the economies in question are not synchronized. If the business cycles of the countries are closely synchronized, then the positive impacts resulting from exchange rate devaluation are limited. When business cycles differ, there is opportunity to spur exports by lowering the exchange rate. As quantitative easing has the impacting of devaluing the currency, it becomes a mechanism to lower the exchange rate (Borio, English & Filardo, 2003). Thus, the U.S. dollar should be lowered against major world currencies as QE is implemented, improving the competitiveness of exporters. Of particular interest is the impact of QE on the dollar-yuan exchange rate. As the Chinese government attempts to combat a rise in the yuan's value, its task is made more difficult by quantitative easing, putting additional pressure on China to allow the yuan to appreciate, a move that would help the U.S. trade balance but would do economic harm to China (Feldstein, 2010).

Criticisms

There appear to be two primary criticisms of quantitative easing. The first is that the policy is unconventional, and therefore should not be used. While it is true that QE is a little-used instrument of monetary policy, it is not so unusual that it should not be tried. This objection does not reconcile with the fact that the Federal Reserve has a number of different tools at its disposal to implement monetary policy, of which QE is just one. The characteristics of the U.S. economy at present -- and especially last fall -- are that of a classic liquidity trap in which zero interest rates are insufficient to produce full employment (Krugman, 2000). This implies that conventional monetary policy in the form of lowering interest rates has already been attempted and is insufficient. It is in this context that quantitative easing is normally used, the classic example being Japan in the late 1990s.

The second criticism of quantitative easing reflects the risks inherent in the strategy. The strategy is criticized for achieving precisely what it intends to achieve -- increasing inflation and devaluing the currency. The currency devaluation argument is usually only conducted on moral grounds -- that devaluing the currency is bad because it is. The economic case for devaluing the currency is apparent from the basic GDP accounting identity: GDP = C + I + G + (X-M). At times when quantitative easing is typically attempted C. And I have not been sufficiently stimulated by interest rates at the zero bound. Fiscal policy has either been proven ineffective or is for one reason or another political infeasible. This leaves X-M as the sole remaining way of improving economic prospects. There are mechanisms by which the balance of trade can be impacted, but many such mechanisms either fall within the realm of fiscal policy, are long-term in nature or both. For the central bank, the ability to influence exchange rates through a policy of quantitative easing is essentially the best tool at its disposal. By devaluing the currency, exports will be encouraged and imports discouraged. This will have the impact of improving the GDP, and this policy will also serve to encourage business investment. This tactic is especially useful in a situation like the present where a demand shock is at least in part responsible for the economic malaise, because currency devaluation helps to stimulate demand on the export markets.

In addition, by bringing export markets into the equation, Bernanke's feedback loop is effectively broken. The feedback loop is based on the economy being relatively contained within the nation's borders -- that is to say the (X-M) equation is largely unchanged during the course of recession and recovery. Quantitative easing is one of the most effective -- and more importantly one of the most immediate -- ways of addressing the (X-M) portion of the GDP identity.

Another key risk cited as a reason not to undertake quantitative easing is the risk of inflation. The policy is designed to spur an increase in inflation in order to allow interest rates to break off of the zero bound. This in turn gives the central bank another tool with which to address the state of the economy. In addition, it should be noted that central banks tend to aim for inflation rates around 2% annually, and for that rate to be held stable. In the current context, inflation rates are much lower, and core inflation has been trending towards deflation. The Japanese situation illustrates some of problems with deflation, including the fact that in a deflationary environment money becomes a substitute for bonds; in a liquidity trap environment they are effectively substitutes for one another, which is bad enough. Bernanke (2009), the Bank of England (2008) and others argue that because the central bank controls the levers to contain inflation, that it is well positioned to address inflation when it becomes too high. Economists are generally in agreement that inflation will rise with quantitative easing, the main issue is when to contain inflation.

Bernanke admits that controlling inflation after a quantitative easing round requires delicate handling of the issue. Because the QE has increased inflation expectations among investors, it is likely that inflation will lead the actual recovery, in particular the unemployment rate. Therefore, the central bank is likely to have to deal with inflation before the recovery is complete. The underlying theory is that rates will be raised when the inflation rate gets above the central bank's target rate. The Fed may need to raise rates quickly in order for this to happen. While it is agreed that the raising of rates needs to be done delicately in order to send the right signals to the market that the inflation situation in under control and the economic recovery will continue, the risks that this is not done effectively are generally considered worthwhile in order to pull the economy out of its recession.

Conclusion

Quantitative easing can be an effective tool of monetary policy for pulling the economy out of recession. Typically QE is only used when other tools are for whatever reason ineffective. In the current situation in the U.S., fiscal policy is a non-starter and interest rates are at the lower bound. While normally low interest rates would spur investment, reduce unemployment and lead to inflation, that has not been the case because the current situation is a liquidity trap, where the increase in liquidity required to restore full employment is more than can be achieved by lowering the interest rate alone. That quantitative easing is a relatively unconventional policy is a critique of the technique, but it should not be -- it is only unconventional during conventional times. During times of liquidity trap, quantitative easing has been used in the past and is particularly necessary when appropriate fiscal policy response is not forthcoming.

The impacts of quantitative easing on the economy are numerous, and each impact serves to perform a specific role leading to economic recovery. The first such impact is that is injects more liquidity into the system. That the current high level of liquidity is as yet ineffective is not a case against quantitative easing -- the relationship between liquidity and employment…

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