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Why the Fed’s $600 billion Quantitative Easing program won’t help decrease unemployment in the U.S.

November 27, 2010

On November 3rd, the Federal Reserve (Fed) announced that it would institute a program to purchase up to $600 billion in long-term treasury Bonds over the next eight months. The move marks the Fed’s second attempt at quantitative easing since the Fed purchased approximately $1.7 trillion housing related assets between December 2008 and March 2010.

As is to be expected, this large injection of cash into the economy was greeted with controversy. The debate over whether quantitative easing can serve to boost the economy through creating jobs and encouraging lending springs from an ongoing debate in macroeconomics between proponents of Real Business Cycle (RBC) Models and the New-Keynesians regarding how the core of the economy functions.

Monetary policy is only really effective when, as New-Keynesians argue, prices are sticky; this means that firms and employees cannot instantly adjust the price of goods and labor to account for changes in the economy. The consequence of this is that short term changes in the nominal interest rate are not instantly matched by one-for-one changes in prices and expected inflation. As a result, putting money into the economy will, in the short-term, affect the real interest rate and create the temporary illusion of more wealth. This artificial new wealth drives growth by creating additional demand, while decreasing the treasury rate lowers the real interest rate to encourage investment. In this situation the result is ideally that businesses increase supply, bringing about changes in consumption and investment that drive up output and employment.

Contrary to this picture, Real Business Cycle proponents posit that monetary policy cannot change the real dynamics of the economy. The RBC model exists in the economic utopia of perfectly competitive and efficiently allocative markets. In this world, changes in the economy are viewed as the optimal result of market forces. According to this model, in the best case increasing the money supply will only serve to increase inflation; and at worst Fed policies distort efficient economic activity by moving prices away from their fair market value. The RBC conclusion is that monetary policy is not useful, and perhaps not surprisingly their models are avoided by those in the Central Bank. While there is significant empirical evidence for price stickiness, RBC’s criticisms of the New-Keynesian model help explain why detractors believe that this type of stimulus will do little to boost the U.S. economy.

Analysis

Whether the Fed’s current moves will lead to inflation in the long term is debatable. Barring this issue, the question of how an increase in the money supply will affect the domestic economy in the short term boils down to whether the economy prices and allocates resources efficiently. Domestically, with high unemployment and underutilization of manufacturing capacity, it seems clear that there is excess capacity in the economy for growth. However, on a global scale things become more opaque. If the intent of quantitative easing is to decrease the cost of domestic loans, drive investment, and increase employment; in a relatively open global economy higher profitability may be found by exporting the created wealth to investments in emerging markets and commodities that produce higher yields. If these investments are more profitable than their domestic counterparts, financial institutions and international corporations will benefit from the low interest rates offered by the Fed without driving any significant domestic growth. Thus if we believe that the global economy is one with relatively free movement of capital to profitable investments, then the U.S. people would be better served by government policies designed to bolster the profitability of U.S. economic activity and create the expectation of long term growth. This could be done through policies such tax breaks targeting domestic loans and job creation, as well as government spending on domestic programs and infrastructure. In a highly globalized economy, the Federal Reserve’s monetary policy may prove ineffective in lowering interest rates for domestic loans and should not be viewed as a substitute for appropriate domestic economic policy.

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