Some further thoughts on QE2

Posted in Economics, Financial Markets, Politics and Policy at 7:54 am

I’ll focus here on what I call “compositional effects” – how the composition of an action (in this case QE) can be more important than the absolute level of the action.

Bernanke has used the metaphor of “dropping money from a helicopter” in past discussions of monetary policy.  The implication is that the Fed could always prevent a deflationary spiral through the use of their “printing press”.  Let’s look at compositional effects as they apply to the helicopter metaphor.  In this case, what matters is who receives the newly created money, or, to extend the metaphor, the location of the helicopter when the drop begins.  Consider for a moment that the banking system is currently sitting on around $1 Trillion in excess reserves and the helicopter drop will simply funnel an additional $75 billion or so per month to these same banks.  Bernanke has effectively positioned the helicopter over a volcano before starting the drop.  When the drop is done, we’ll likely have $1.6 Trillion in excess reserves with very little net change in the real economy.  Perhaps a smaller drop, with the helicopter instead positioned over Main Street would have been a wiser move.

Now let’s look at QE and inflation expectation through the lens of compositional effects.  Changes in inflation expectations have been put forward by numerous economists, including Paul Krugman, as the primary mechanism through which QE will stimulate the economy.  This makes sense if price level changes, or rather the expectation of future price level changes, are more or less homogenous throughout the economy.  What happens if they are not?  What happens if the primary effect of QE is to increase the prices of commodities (oil, food, metals, etc.) but not finished goods or labor?  This would result in a sort of reverse wealth effect for individuals (who could now consume less energy and food out of a constant income) and declining profitability for firms (who face rising input costs and constant output prices).  The net effect would be a decline in aggregate demand.  Compositional effects matter.

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