I have noted several times now that our current economic problems are fundamentally the result of excess money demand. This understanding implies QE2 is ultimately about solving an excess money demand problem. Along these lines, Josh Hendrickson notes that the current excess money demand problem is unique because the Fed is paying interest on excess reserves:
With the Fed paying interest on reserves, open market operations literally entails the Fed exchanging debt for debt — specifically, Federal Reserve debt for Treasury debt... it should be clear that the Fed is not being expansionary when it exchanges debt for debt. Nonetheless, this is not the same thing as saying that the Fed cannot be expansionary.Read the rest of Josh's post here. By the way, Josh just finished his Ph.D. and is on the job market. Give him a look.
Some commentators have assumed that the sole effect of quantitative easing is to reduce long-term interest rates and stimulate investment. This is wrong-headed and demonstrates... why obsessions with the interest rate effect are misguided. The point of quantitative easing is not to reduce the long-term interest rate, but rather to resolve monetary disequilibrium.
Suppose that there is an excess demand for money. Since money is the medium of exchange and is traded on all markets, this necessarily causes an excess supply of goods and services. The central bank can eliminate the excess demand for money by increasing the money supply. However, as has been discussed above, if the central bank is exchanging interest-bearing reserves for interest-bearing debt, it is essentially exchanging perfect substitutes. If this is the case, traditional open market operations will not resolve the excess demand for money. Rather, the central bank needs to exchange the interest-bearing reserves for something that is not a perfect substitute. Potential assets that satisfy this criteria could be anything from long-term bonds to a portfolio of stocks. The central bank purchases these assets in order to increase the money supply and resolved monetary disequilibrium.
Not really an excess demand for money so much as a tremendous demand for safe assets (this of course is the argument Caballero has been making for some time). Now perhaps the even deeper factor here is the low expected return on real investment projects. Investment has been low for a decade now.
ReplyDeleteUltimately this is a real-side problem - why have we already had a weak decade of low investment, weak labor market and poor growth - a weakness that forced the Fed to confect a housing bubble to paper it over ?
If there's an excess demand for money, why is nobody willing to pay me for mine?
ReplyDeleteI'm serious---if the system needs more cash, why are interest rates so low?