Filling the gap between theory and application of QE

I am still between 3-4 months away from beginning my study. Nevertheless, it will not hurt me to start early. Below are some of my initial thoughts.

Once short-term interest rates are close or at zero percent, there are several ways that a central bank can keep stimulating the economy. Those are by (i) expanding the size of its balance sheet (a.k.a quantitative easing), (ii) announce its future plans (a.k.a. forward guidance), or (iii) keep pushing the interest rates into the negative territory.

Let's focus on the first tool mentioned since it is familiar to everyone. So far, what I saw was the explanations of how quantitative easing works in theory and empirical evidence of this policy.

Nonetheless, what most literature that I found so far were not able to explain the connection between theory and empirical evidence. If I have to illustrate visually, I would draw a Venn diagram, and will look something like this:

The gap (shaded area) is something that still puzzles me.

One of the papers I read that studied Japan's experience of quantitative easing programme back in 2001 to 2006 by Tsuji (2006) did a great job of perfectly explain the theory and the effectiveness of the programme, especially its impact on the real economy. Most papers out there focused extensively on QE's impact on the financial market, and this paper is one of few that really studied its impact on the real economy. While the author was not able to connect the theory and the evidence found from the research, the author argued that quantitative easing could work via two different channels. Those are through (i) expectation channel or (ii) portfolio substitution. 

The author also pointed out three crucial papers that might answer the gap that I showed above. Those papers are:

• Bernanke, B. S., & Reinhart, V. R. (2004). Conducting monetary policy at very low short-term interest rates. American Economic Review, 94, 85–90
• Bernanke, B. S., Reinhart, V. R., & Sack, B. P. (2004). Monetary policy alternatives at the zero bound: An empirical assessment. Brookings Papers on Economic Activity, 35, 1–100.
• Tobin, J. (1969). A general equilibrium approach to monetary theory. Journal of Money, Credit and Banking, 1, 15–29.

For my next post, I will summarize these three papers.

Source(s)

Tsuji, C. (2016). Did the expectations channel work? Evidence from quantitative easing in Japan, 2001-06. Cogent Economics and Finance, 4(1).