Must ‘quantitative easing’ end in inflation?
For anyone playing the wildly popular online role-playing game Diablo 3 back in May, the
effects of an expansion of the monetary base on the price level were evident. For the
uninitiated, some background detail would be helpful. Each player controls one character
in a world also populated by the characters of other players. The game proves interesting
study for economists due to the way in which scarce in-game items are allocated; through
an auction house, where players bid for items being sold by other players. By doing this
the auction house essentially creates a market for each item in the game, with price being
determined by the interaction of supply and demand. In May, a bug in the game allowed
players to quickly add massive amounts of gold, the in-game currency, to their account in
a very short period of time. The result: prices for most goods in the auction house shot
up. For example the radiant star ruby, which had been hovering just above 20 million
gold for the previous 6 months, shot up to 85 million in one day. However the most
interesting price change to note was in the price of gold itself. Players can buy in-game
gold using real money; this is one of the ways the producers profit from the game. The
price of 10 million gold had been dead stable at $2.50 for the previous 3 months, before
falling to 39 cents in one day, reflecting the reduced purchasing power of gold in-game.
While the events of Diablo 3 are perhaps the most recent, history abounds with such
examples. Liberal printing of money led to hyperinflation in Zimbabwe in 2008 and in
the 1920s Weimar Republic. Even further back than that, when the value of coins was
linked to the precious metal contained within them, prices in Europe quadrupled during
the 16th Century when gold and silver began flowing into Europe from the newlydiscovered Americas, driving down the value of the precious metals contained in each
coin.
When looking to explain these effects of a changing monetary base, we could first look at
the work of Irving Fisher, an American economist prominent in the early 20th Century.
He noticed that the amount of money in the economy, multiplied by the number of times
money changes hands in a given time period (the velocity of money), must be equal to
total expenditure in the economy over that time period. Similarly, the total expenditure
in the economy in a given time period must be equal to the general price level multiplied
by the goods sold during that time. Combining these two statements gives the identity:
MV=PQ (Fisher’s equation of exchange)
This identity underpins the quantity theory of money. When it is assumed that the
velocity of money and the quantity of goods produced is constant, it becomes clear that
there is a constant ratio between the monetary base and the price level; a change in the
monetary base will lead to a proportional change in the price level. This theory directly
implies another, the neutrality of money. First proposed by Friedrich Hayek in 1931; the
idea behind the theory is that money can only influence nominal variables in the
economy, such as price, with no effect on real variables, such as inflation-adjusted GDP, as
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Must ‘quantitative easing’ end in inflation?
any increase in the monetary base will be completely offset by the proportional rise in
prices.
So with this knowledge of the link between the monetary base and the price level, we
should be able to answer the question as to whether quantitative easing (QE) must always
end in inflation. QE was first implemented by the Bank of Japan in 2001 as an attempt to
use monetary policy to stimulate a stagnant economy while interest rates were down
against the zero lower bound, a situation nowadays referred to as a liquidity trap. QE
entails the government electronically creating funds and using these funds to buy various
securities from banks. When people deposit savings into a bank, the banks loans out some
of the money in order to make a profit, but it has to keep some of the deposit within the
bank, so it isn’t overextended and can pay out money to people who want to withdraw
their savings. This is known as fractional reserve banking. The requirement for reserves
has increased as a result of the international Basel III agreement. If banks are liquidity
constrained, they will be unable to lend money, which is where QE comes in. Buying
assets from banks floods them with liquidity, which will hopefully enable and encourage
private lending, by giving banks reserves well above the levels they need, leaving them
with little risk of a liquidity shortage. In the case of Japan, the assets the central bank
bought up were mainly long term government bonds. More recently the US Federal
Reserve has conducted QE via buying up mortgage backed securities and carrying out
liquidity swaps with other central banks. Since then, the Fed has also begun to buy up
government securities.
The reason we may expect QE to lead to inflation is that in electronically creating funds to
buy securities the government expands the monetary base. So by the quantity theory of
money we would expect an increase in the price level proportionate to the increase in the
monetary base. Looking at recent economic data from Japan and the USA …
Index (Jan 2008 =100)
The Monetary Base and the CPI in the
USA since 2008
400
350
300
250
200
150
100
50
0
2008
CPI
Monetary Base
2010
2012
2014
Year
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Must ‘quantitative easing’ end in inflation?
The Monetary Base and the CPI in
Japan since 2001
Index (Jan 2001 = 100)
250
200
150
CPI
100
Monetary Base
50
0
2001
2006
2011
2016
Year
… we don’t see that relationship at all. We would expect proportionality to be clearly
visible when using indices as the lines would more or less follow the same path, yet here
this is evidently not the case. In the example of Japan, we actually have deflation
accompanying a quantitative easing program that is massively increasing the monetary
base. There are other factors at work here though, which have influenced the price level.
In Japan, an ageing and contracting population is reducing demand for goods. At the same
time, fear of bank insolvency has encouraged many Japanese to buy treasury bonds as
opposed to saving their money in a bank account, meaning there has been no money
available for lending, again reducing demand for goods. Deflation itself is selfexacerbating, as the Yen strengthens reducing the cost of imports and people hold out on
buying goods in case of further price drops. Nonetheless we would expect such a huge
change in the monetary base to override these factors, meaning that we can still conclude
that there is no significant relationship between the monetary base and the price level in
these situations.
So, do these results invalidate Fisher’s equation of exchange? Not quite! This equation is
an identity – it holds in all situations. We should look instead at the assumptions that the
velocity of money and the quantity of goods remain constant. The cases of Japan and the
USA suggest that at least one of these is incorrect.
First we’ll examine the assumption that the velocity of money stays constant. This
assumption was challenged by John Maynard Keynes, a British economist who lived
through the years of the Great Depression and is arguably the father of modern economic
thought. He argued that money is used not just as a medium of exchange while buying
and selling goods, but also as a store of value, in that it can be saved today to be spent later.
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Must ‘quantitative easing’ end in inflation?
Keynes argued that money’s use as a store of value is determined by the interest rate.
Using money as a store of value has an opportunity cost, which is the assets that could be
bought with that amount of money. You might hold assets instead of cash, as assets have
the advantage of earning interest over time. This idea is referred to as liquidity preference
theory. The advantage of holding money is that it can be used at will, whereas with assets,
converting into hard cash can be more difficult. When interest rates are high, assets yield
higher returns, so people are inclined to hold assets. In our current situation, where
interest rates are near-zero as a result of measures taken to stimulate the stagnating
economy, there is next to no opportunity cost to holding money; individuals and
corporations will forgo what little profit they may receive on assets in order to have cash
on hand. The effect is compounded, as individuals are particularly wary of bonds in zero
interest rate situations, as interest rates cannot fall any further. Once the economy has
recovered and interest rates rise again, the price of bonds will fall. The significance of
liquidity preference theory for QE is that when money is being held as a store of value at
the margin, the money banks receive from QE is primarily padding out their cash reserves,
without it ever really entering the economy. Think back to the Fisher equation of
exchange and separate the new money created by QE and the money that already existed.
MV + M1V1 = PQ
If the new money created simply sits in a bank’s reserves, its velocity will be zero, and
hence there will be no change in the value PQ.
Now we’ll look at the assumption that the quantity of goods produced by the economy
remains constant following a change in the monetary base. Consider when Milton
Friedman remarked that the USA could fight price deflation by printing money and
dropping it from a helicopter. Although it was mentioned by Ben Bernanke, now the
Chairman of the Federal Reserve, back in 2002, it seems like an absurd policy. However,
you could consider a £1,000 fixed tax break financed by the central bank purchasing
government bonds equivalent to a helicopter drop. Clearly this is simply expansionary
fiscal policy financed by QE, which sounds like a more plausible policy option, although
lacking the drama of money falling from the skies. Aggregate demand would inevitably
increase, as families now have more disposable income they can spend on goods.
When thinking about the effects of QE on aggregate demand, we should also think about
the impact QE has on long term interest rates. When the central bank decides to buy
bonds and other securities, the price of the bonds increases due to the increase in demand.
The yield on these securities, which is usually a fixed nominal value for the term of the
bond, decreases as a percentage of its value, and this decrease in percentage yield should
trickle through the economy to rates on loans, credit cards and mortgages. With interest
rates lowered, aggregate demand will increase as it is cheaper to borrow money.
Investment in particular should pick up as most investment is financed through
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Must ‘quantitative easing’ end in inflation?
borrowing. Usually this would lead to an increase in the price level; in fact this would be a
typical case of demand-pull inflation. However this may not occur under some
circumstances.
The recession has caused a lack of demand in the economy – that much is clear. When UK
house prices fell in 2007, people and corporations began slashing their spending in an
attempt to reduce debt. This fall in aggregate demand creates an output gap, where a
country produces fewer goods than its capabilities allow it to. In 2009, the UK was
estimated to have had an output gap of roughly 4% of GDP, which shows just how
significant the effects of the recession have been. Clearly the output gap means that there is
unemployed capital in the economy. Keynes told us that prices are sticky. Hence with a
large amount of unemployed capital, when demand increases firms are willing to increase
output without increasing prices. This leads to the conclusion that the aggregate supply
curve is fully elastic when there are large amounts of unemployed resources. The
importance of the above is that an increase in aggregate demand, caused by both reduced
long term interest rates and the potential for some new money to leak into the economy,
would not have to be inflationary if it put unemployed resources to use.
And yet, the above cases only concern the short run. Friedman, Keynes and Hayek,
arguably the three titans of 20th century economics, all told us that in the long run money
is neutral, so surely inflation must occur eventually? When the economy recovers, banks
will start to lend their reserves and the velocity of money will increase back towards
‘normal’ levels. Aggregate demand will recover to the point where it intersects on the
upwards sloping section of the aggregate supply curve, and the price level will be higher
than it would otherwise have been without the increase in the monetary base. This is the
case, which is why the central bank will start contracting the monetary base once the
economy starts to recover, thus never allowing inflation to be realised.
There are
numerous ways a central bank can do this, known as ‘exit strategies’.
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Must ‘quantitative easing’ end in inflation?
Essentially, if the central bank has bought up lots of assets, it can start selling them,
destroying the money it receives from sales. The central bank can also raise interest rates,
which will encourage people to switch away from holding money, reducing inflationary
pressure. Sadly however, the solution is unlikely to be as simple as dumping assets and
hiking interest rates. If this happens too abruptly, before the economy is ready, then the
green-shoots of recovery could be trodden underfoot, as was the case following the rise in
interest rates in Japan in 2006. Furthermore, instantly calling a halt to QE could lead to a
spike in bond yields, which would be potentially problematic. In order to give itself more
flexibility with regard to the timing of monetary tightening, the central bank could pay
interest on cash reserves stored there, as the Federal Reserve has just been given permission
to do. This would delay bank reserves flooding into the economy, as banks would not
lend them out at rates less than the rate earned for storing reserves risk-free at the central
bank. Another tool the central bank could use is reverse repurchase agreements, where
the central bank sells assets and promises to buy them back later for a higher price. In
fact, these stall strategies could allow the central bank to let its assets mature, as opposed to
selling them and risking hefty losses.
In summary, a look at the effects of QE and the possible exit strategies seems to provide
the answer to the question posed. Quantitative easing, in the short run, need not be
inflationary – and even in the long run it doesn’t have to end in inflation, as it is a
temporary and fully reversible measure. Getting the exit right, however, may be more
complex than patching a video game.
2433 words excluding bibliography
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Must ‘quantitative easing’ end in inflation?
Bibliography
Diablo 3 Price Tracker - http://www.diablohub.com/auction-house/
US Department of Labour Statistics – CPI - ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Federal Reserve - Aggregate Reserves of Depository Institutions and the Monetary Base http://www.federalreserve.gov/releases/h3/default.htm
Official Statistics of Japan – 2010 base Consumer Price Index http://www.e-stat.go.jp/SG1/estat/ListE.do?bid=000001033702&cycode=0
Bank of Japan Statistics – Monetary Base – www.boj.or.jp/en/statistics/boj/other/mb/mblong.zip
DK – The Economics Book – Pages 30-33 – Money Causes Inflation
Alan S. Blinder – Quantitative Easing: Entrance and Exit Strategies http://www.princeton.edu/ceps/workingpapers/204blinder.pdf
Simon Wren-Lewis - Mainly Macro – Money and Inflation – 21st December 2011
http://mainlymacro.blogspot.co.uk/2011/12/money-and-inflation.html
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2012 http://mainlymacro.blogspot.co.uk/2012/10/what-do-people-mean-by-helicoptermoney.html
Paul Krugman – Conscience of a Liberal – Monetary Policy in a Liquidity Trap – April 11th 2013
http://krugman.blogs.nytimes.com/2013/04/11/monetary-policy-in-a-liquidity-trap/?_r=0
The Economist – The President Speaks – June 4th 2009 http://www.economist.com/node/13768746
Ben Bernanke – The Fed’s Exit Strategy – The Wall Street Journal – July 21st 2009
http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html
Nouriel Roubini and David Backus – Lectures in Macroeconomics – The IS/LM Model
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Stephanie Flanders – Should Bank start the helicopter? – BBC – 12th October 2012
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Kenji Nishizaki, Toshitaka Sekine, Yoichi Ueno – Chronic Deflation in Japan
http://www.boj.or.jp/en/research/wps_rev/wps_2012/data/wp12e06.pdf
Tom Pybus – Office for Budget Responsibility – Estimating the UK’s historical output gap
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