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Quantitative Easing:
A Tutorial
Revised March 2013
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Behind the Mystery of 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 most mysterious
instruments is Quantitative Easing
or QE
 This tutorial attempts to explain the
mechanics of QE and its effects to
date 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 March 2013 Ed Dolan’s Econ Blog
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 March 2013 Ed Dolan’s Econ Blog
The Central Bank Balance Sheet: Liabilities
 The sum of the items on the
liabilities side of the balance sheet
are called the monetary base,
which consists of two parts
 Reserve deposits that private
commercial banks hold with the
central bank
 Currency (paper money and
coins)
Revised version March 2013 Ed Dolan’s Econ Blog
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 March 2013 Ed Dolan’s Econ Blog
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 March 2013 Ed Dolan’s Econ Blog
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)
 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 March 2013 Ed Dolan’s Econ Blog
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 open secondary
markets—hence the name “open market”
operations.
Note: This and subsequent slides use “Taccounts,” which are simplified balance
sheets that only show items that change
as a result of whatever operation we are
discussing
Revised version March 2013 Ed Dolan’s Econ Blog
Open Market Operations Step-by-Step
 Step1: The central bank adds to its
holdings of domestic securities by buying
them from security dealers or other
members of the public
 Step 2: 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 3: 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 March 2013 Ed Dolan’s Econ Blog
Further effects of open market operations
 The first three steps in the open market
operation result in an increase in bank
reserves and a equal increase in the
money stock, in the form of bank
deposits
 To complete the story, banks may use
the added reserves as a basis for making
new loans. If they do, the proceeds of the
loans are paid out to the borrowers in the
form of added bank deposits. The result
is a further multiple expansion of the
money supply beyond the immediate
impact of the open market operation
Revised version March 2013 Ed Dolan’s Econ Blog
What is Quantitative Easing?
 In normal times, an increase in bank
reserves pushes down market interest
rates and encourages investment, so that
even a relatively small open market
operation can stimulate the economy
 However, when interest rates are near
zero, as they have been during the crisis,
very large purchases of assets may be
needed to have any significant effect on
the economy.
 Such very large central bank purchases
of assets, including long-term as well as
short-term securities, are known as
quantitative easing (QE)
Revised version March 2013 Ed Dolan’s Econ Blog
Giving QE a Try
 Early in the crisis, the Fed
undertook a large scale asset
purchase program, now known as
QE1, which resulted in a huge
increase in the monetary base
 The money stock increased only
slightly, because bank lending did
not increase as much as reserves
 Even though the money stock grew,
the velocity of its circulation through
the economy fell and nominal GDP
continued to decrease.
Revised version March 2013 Ed Dolan’s Econ Blog
From QE1 to QE2
 Because QE1 failed to get the
economy back on track, from late
2010 to mid-2011, the Fed carried
out an additional large scale
purchase of assets that became
known as QE2
 Although there is some evidence
that QE2 lowered long-term interest
rates, the recovery remained slow
Revised version March 2013 Ed Dolan’s Econ Blog
Now QE3
 In September 2012 the Fed decided
to begin a new round of easing, QE3
 QE3 will buy $40 billion per month of
mortgage-backed securities, and will
continue some other bond-buying
programs
 Unlike QE1 and QE2, QE3 has no
specified end date. It will continue
until the economy improves by
enough to justify ending it
Revised version March 2013 Ed Dolan’s Econ Blog
Recycling Interest Payments
 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.
 Does that mean that QE has no cost, so
that there is, after all, such a thing as a
free lunch?
 In the short run, yes, but there are two
important qualifications
The Fed
The Treasury
Treasury photo by David Monack, http://commons.wikimedia.org/wiki/File:GallatinTreas.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
Qualifications to the Free Lunch Theory of QE
 Qualification No 1: Since 2008, the Fed
has begun paying interest on banks’
reserve deposits, so not all the interest
is recycled. The “free lunch” is at best a
lunch at a discount price
 Qualification No. 2: The Fed will not be
able to hold its big QE purchases of
bonds forever. Sooner or later, the
economy will begin to recover. The
Fed’s exit strategy from QE will require
selling off most of the extra securities to
prevent excess money growth and the
risk of inflation. Under some conditions,
it might have to sell them at a loss
Photo: © BrokenSphere / Wikimedia Commons
Revised version March 2013 Ed Dolan’s Econ Blog
Has Quantitative Easing Worked?
 Fed Chairman Ben Bernanke has
cited estimates that QE1 and QE2
together lowered long-term interest
rates by 0.8 to 1.2 percentage
points
 The estimates suggest that output is
3 percent higher than it otherwise
would be and about 2 million jobs
were created
 Some independent observers think
the impact has been smaller than
the Fed’s estimates
Fed Chairman Ben Bernanke
Source: Fed official portrait via Wikimedia Commons
Revised version March 2013 Ed Dolan’s Econ Blog
How Does QE Work?
 Standard theory says that in normal times
monetary policy works by lowering interest
rates, so how can QE work when short-term
interest rates are already zero?
 One theory says that it works by changing
the relative amounts of long- and short-term
securities, thereby lowering long-term rates
 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
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
Jackson Hole, Wyoming
Source: Enricokamasa via
http://commons.wikimedia.org/wiki/File:Corbet%27s_Couloir_jackson_h
ole.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
Will QE Save the US Economy?
 There is substantial evidence that QE
has made the economy somewhat
better off than it would otherwise have
been
 However, we also need responsible
fiscal policy. In Fed Chairman
Bernanke’s words
 It is critical that fiscal policymakers put in
place a credible plan that sets the federal
budget on a sustainable trajectory in the
medium and longer runs.
 Monetary policy cannot achieve by itself
what a broader and more balanced set of
economic policies might achieve.
Source of quotes: Speech of Aug 31,2012
Revised version March 2013 Ed Dolan’s Econ Blog
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