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quantitative easing

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On the 3rd of November the Federal Reserve Bank in the US announced its second
round of quantitative easing (QE). The Fed said it will buy $600 billion of Treasuries between
now and next June, at about $75 billion a month.
Explain the purpose of this policy and discuss potential risks associated with it.
Describe the impact on output, unemployment, interest rates and prices in the short
and medium run. How effective do you expect this policy to be and what factors does
its efficacy depend on?
_ There is a whole lot of materials available online in the form of articles (see, for example,
The Economist, Financial Times, BBC news), blog posts of famous economists
(such as Paul Krugman, Gregory Mankiw, David Andolfatto), etc, on this topic.
Some of the opinions expressed in these articles criticize the policy, while others
support it. You can consult any of these sources for your answer and you can agree
or disagree with them; however, you must justify your answer using the macroeconomic
tools we have learned so far. That is, in constructing your argument you
should clearly explain what economic models you base your answer on, what the
assumptions of those models are and whether they are likely to be true, and what
predictions these models have related to the question above. You can use standard
textbook diagrams, data series graphs or other materials you find to illustrate your
_ To help you structure your thoughts, these are a few things you may want to address
when answering this question: a difference between demand and supply shocks, the
short-run and medium-run effects of the monetary policy, the liquidity trap, a role
of expectations and credibility of the Fed's policy.

Solution Preview

The theory behind quantitative easing is that monetary policy can be used by the Central bank to increase the supply of mainly, increase the availability of money and decrease the cost of money and these can bring about growth and stability of the economy. the fundamental theory is that according to the monetary policy thee is a relationship between rates of interest and the total supply of money. The government believes that changing the supply of money can bring about economic growth, control inflation, reduce unemployment, and influence the exchange rate with other currencies.
Normally, the monetary policy is implemented through bank interest rate, discount rate, inter-bank interest rate. Now the situation because of the recent recession is that keeping the interest rate close to zero has failed to have much effect and so the Federal Reserve has to take the extreme measure of using quantitative easing. In case of quantitative easing, the Federal Reserve creates money in its own account and uses that to buy the central government's own bonds. This injects money direct into the system and creates extra reserves in the banking system. The method used is called open market operations. The purchases made by the Federal Reserve create new money and according to the monetary policy should be able to stimulate the economy through deposit multiplication.
How did the situation arise where quantitative easing had to be used? The reason given for this is the liquidity trap. This is a situation where monetary policy is unable to stimulate the economy. According ...

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