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Friday, October 12, 2012

Qualitative Easing: How it Works and Why it Matters

From the Fed conference in St. Louis, Roger Farmer makes what I think is a useful distinction between quantitative easing and qualitative easing (the distinction, first made by Buiter in 2008, is useful inependent of his paper; in the paper he argues that it's the composition of the balance sheet, not the size, that matters -- in the model people cannot participate in financial markets that open before they are born leading to incomplete participation -- qualitative easing works by completing markets and having the Fed engage in Pareto improving trades):

Qualitative Easing: How it Works and Why it Matters, by Roger E.A. Farmer: Abstract This paper is about the effectiveness of qualitative easing; a government policy that is designed to mitigate risk through central bank purchases of privately held risky assets and their replacement by government debt, with a return that is guaranteed by the taxpayer. Policies of this kind have recently been carried out by national central banks, backed by implicit guarantees from national treasuries. I construct a general equilibrium model where agents have rational expectations and there is a complete set of financial securities, but where agents are unable to participate in financial markets that open before they are born. I show that a change in the asset composition of the central bank’s balance sheet will change equilibrium asset prices. Further, I prove that a policy in which the central bank stabilizes fluctuations in the stock market is Pareto improving and is costless to implement.
1 Introduction Central banks throughout the world have recently engaged in two kinds of unconventional monetary policies: quantitative easing (QE), which is “an increase in the size of the balance sheet of the central bank through an increase it is monetary liabilities”, and qualitative easing (QuaE) which is “a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet.”[1]
I have made the case, in a recent series of books and articles, (Farmer, 2006, 2010a,b,c,d, 2012, 2013), that qualitative easing can stabilize economic activity and that a policy of this kind will increase economic welfare. In this paper I provide an economic model that shows how qualitative easing works and why it matters.
Because qualitative easing is conducted by the central bank, it is often classified as a monetary policy. But because it adds risk to the public balance sheet that is ultimately borne by the taxpayer, QuaE is better thought of as a fiscal or quasi-fiscal policy (Buiter, 2010). This distinction is important because, in order to be effective, QuaE necessarily redistributes resources from one group of agents to another.
The misclassification of QuaE as monetary policy has led to considerable confusion over its effectiveness and a misunderstanding of the channel by which it operates. For example, in an influential piece that was presented at the 2012 Jackson Hole Conference, Woodford (2012) made the claim that QuaE is unlikely to be effective and, to the extent that it does stimulate economic activity, that stimulus must come through the impact of QuaE on the expectations of financial market participants of future Fed policy actions.
The claim that QuaE is ineffective, is based on the assumption that it has no effect on the distribution of resources, either between borrowers and lenders in the current financial markets, or between current market participants and those yet to be born. I will argue here, that that assumption is not a good characterization of the way that QuaE operates, and that QuaE is effective precisely because it alters the distribution of resources by effecting Pareto improving trades that agents are unable to carry out for themselves.
I make the case for qualitative easing by constructing a simple general equilibrium model where agents are rational, expectations are rational and the financial markets are complete. My work differs from most conventional models of financial markets because I make the not unreasonable assumption, that agents cannot participate in financial markets that open before they are born. In this environment, I show that qualitative easing changes asset prices and that a policy where the central bank uses QuaE to stabilize the value of the stock market is Pareto improving and is costless to implement.
My argument builds upon an important theoretical insight due to Cass and Shell (1983), who distinguish between intrinsic uncertainty and extrinsic uncertainty. Intrinsic uncertainty is a random variable that influences the fundamentals of the economy; preferences, technologies and endowments. Extrinsic uncertainty is anything that does not. Cass and Shell refer to extrinsic uncertainty as sunspots.[2]
In this paper, I prove four propositions. First, I show that employment, consumption and the real wage are a function of the amount of outstanding private debt. Second, I prove that the existence of complete insurance markets is insufficient to prevent the existence of equilibria where employment, consumption and the real wage differ in different states, even when all uncertainty is extrinsic. Third, I introduce a central bank and I show that a central bank swap of safe for risky assets will change the relative price of debt and equity. Finally, I prove that a policy of stabilizing the value of the stock market is welfare improving and that it does not involve a cost to the taxpayer in any state of the world.

10 Conclusion An asset price stabilization policy is now under discussion as a result of the failure of traditional monetary policy to move the economy out of the current recession. Most of the academic literature sees the purchase of risky assets by the central bank as an alternative form of monetary policy. In this view, if a central bank asset policy works at all, it works by signaling the intent of future policy makers to keep interest rates low for a longer period than would normally be warranted, once the economy begins to recover. In my view, that argument is incorrect.

Central bank asset purchases have little if anything to do with traditional monetary policy. In some models, asset swaps by the central banks are effective because the central bank has the monopoly power to print money. Although that channel may play a secondary role when the interest rate is at the zero lower bound (Farmer, 2013), it is not the primary channel through which qualitative easing affects asset prices. Central bank open market operations in risky assets are effective because government has the ability to complete the financial markets by standing in for agents who are unable to transact before they are born and it is a policy that would be effective, even in a world where money was not needed as a medium of exchange.

I have made the case, in a recent series of books and articles (Farmer, 2006, 2010a,b,c,d, 2012, 2013), that qualitative easing matters. In this paper I have provided an economic model that shows why it matters.

[1] The quote is from Willem Buiter (2008) who proposed this very useful taxonomy in a piece on his ‘Maverecon’ Financial Times blog.
[2] This is quite different from the original usage of the term by Jevons (1878) who developed a theory of the business cycle, driven by fluctuations in agricultural conditions that were ultimately caused by physical sunspot activity.

    Posted by on Friday, October 12, 2012 at 11:46 AM in Academic Papers | Permalink  Comments (48)


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