One way to think about things is that there are three important macroeconomically-relevant prices in financial markets. (1) There is the liquidity discount: how much you have to pay in order to hold your investible wealth in a form in which you can spend rather them in the form in which it grows. (2) There is the slope of the intertemporal price system: the real interest rate at which safe invested wealth grows. (3) And there is the risk premium: how much extra you get on average for being willing to bear the risks of enterprise and battle the forces of time and ignorance.
Conventional monetary policy tools focus on the first. But in so doing, they may create distortions in the second as they try to correct problems with the first. And what if the root cause of financial distress is the third: the combination of a collapse in the investor willingness to hold risky assets coupled with a collapse in the financial intermediaries ability to credibly promise to create safe assets?
It is in those situations that nonstandard monetary policy tools–interest on reserves, quantitative easing, and other things–come into their own. But what do they do? How do they work? Do they work?
Let me turn the microphone over to one of the smartest and most thoughtful analysts today, Joe Gagnon:
Continue reading “Joe Gagnon Responds to Michael Woodford, Ben Bernanke, and Others on the Risks and Power of Quantitative Easing: Friday Focus (December 20, 2013)” →