Wednesday, December 15, 2010

Quantitative Easing Explained

I disagree with both of the following videos. But the question I pose to TPS readers (and co-bloggers) is: which of the two videos more accurately describes your position on quantitative easing. Alternatively, feel free to post what you hate about each video.


Anonymous said...

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KipRsquire said...

The second video is pure partisan hackery.

One more time: Quantitative easing is open market operations in a mini-skirt. Open market operations is an expansion of the money supply, also known in certain circles as debasing the currency. All else is sophistry.

Also one more time: "Deflation" means that gasoline and corn flakes and toilet paper will be cheaper. Oh the horror!

Will Luther said...

Kip: Both videos are partisan. However, I think the latter makes a better economic argument--even though I disagree with its conclusions.

Deflation means that consumer goods cost less (nominally). But it also means that wages are lower (nominally). Savers can consume more, as their net wealth increases. But borrowers can consume less, as they have to pay back what they borrowed with more expensive dollars. This is merely a transfer, of course, so there is no obvious reason why we should prefer one group to gain at the expense of the other.

Most economists agree that output is determined by the productive capability of the economy. Many accept short run deviations (positive or negative) from full employment. Hence, deflation in the absence of some increase in the productive capabilities of the economy implies that, at best, we are producing and consuming at the natural rate of output (this occurs when the deflation has occurred to the extent necessary to account for the monetary contraction) and, at worst, we are under producing/consuming (this occurs when prices have not yet adjusted far enough downward). Hence, individuals do no better under deflation and might do worse.

The real problem with a falling aggregate price level (ignoring falling prices stemming from technological change) is that it is costly with no offsetting benefit. Take the simple case where all prices fall instantly and in unison. Since the lower prices are not conveying anything meaningful about the world (i.e., they are not reflecting a change in relative scarcity), they serve their epistemic role no better than the higher prices. Presumably the act of changing prices is costly however. Menu costs may be trivial, but they are positive. And there is no corresponding benefit to offset these costs.

The more complex case where prices do not fall in unison but must be discovered through the market process only makes the case against a falling price level stronger (again, we are ignoring falling prices stemming from technological change). Here, the prices change asymmetrically and prompt individuals to make errors. So you now have the the menu costs PLUS the costs from the additional errors.

It is true that increasing M debases the currency. I presume that your argument--if you are making an economic argument--is that debasing the currency is inflationary and, hence, results in unnecessary menu costs and the costs from additional errors. But deflation from a falling M has the same kind of costs! And just like we should discourage central banks from arbitrarily increasing the money supply, we should also discourage them from arbitrarily decreasing the money supply.

Now the actual course of events is a little more complicated. We would have to insert expectations and discuss M growing at faster or slower rates than expected. Still, the argument is analytically unchanged.

Also, it is of course not the case that the central bank just decided to decrease M (or allow M to grow at a rate less than expected). Rather, banks increased reserve ratios (in part because they were paid to do so). Still, in a fractional reserve system, a change in the money multiplier is analytically equivalent to a change in M as outlined above.

In cases where the money supply is falling, the proper response for the central bank is to prevent this from happening. We do not an excess demand or supply of money.