Understanding the Limitations of Quantitative Easing and Nonconventional Monetary Policy

Limitations of Quantitative Easing and Nonconventional Monetary Policy

Zero Lower Bound and Deflation

While quantitative easing (QE) and other nonconventional policies can be employed when short-term interest rates reach the zero lower bound, they are not a cure-all. When the economy faces deflationary conditions, designing effective policies becomes challenging due to the increased uncertainty surrounding their outcomes. Additionally, nonconventional policies like QE are more complex to implement, making it harder to effectively stimulate the economy.

Reserve Demand and Federal Funds Rate

If the actual demand for reserves exceeds the estimated demand, the actual reserve demand curve will shift to the right. If the gap is significant, the demand and supply curves for reserves will intersect on the horizontal portion of the reserve supply curve. Since banks can obtain any quantity of reserves they require through discount loans, they will not borrow in the federal funds market at a rate higher than the discount rate. Therefore, regardless of the extent of the underestimation of reserve demand, the market federal funds rate will not rise more than 100 basis points above the target.

Impact on Real Interest Rate

The targeted federal funds rate is calculated as:

``` Targeted federal funds rate = 2 + current inflation + 1/2 inflation gap + 1/2 output gap ```

If inflation increases by 3 percentage points, the target fed funds rate will increase by 4.5 percentage points (3 percentage points due to the direct impact of inflation and another 1.5 percentage points due to an increase in the inflation gap). The target federal funds rate is a nominal interest rate. To determine the impact on the real interest rate, we can use the Fisher equation:

``` Nominal interest rate = real interest rate + inflation ```

Therefore, if the nominal rate increases by 4.5 percentage points and inflation increases by 3 percentage points, the real interest rate will have increased by 1.5 percentage points.