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The Fed argued that QE3 would work to reduce the unemployment rate. Use the federal funds market, the AD-AS model, and the yield curve, show and explain how QE3 was supposed to impact short and long term interest rates, as well as P, Y, and N according to the Fed.  Discuss why QE3 may not work as advertised.  In other words, what are the limitations of QE?

Question

The Fed argued that QE3 would work to reduce the unemployment rate. Use the federal funds market, the AD-AS model, and the yield curve, show and explain how QE3 was supposed to impact short and long term interest rates, as well as P, Y, and N according to the Fed.  Discuss why QE3 may not work as advertised.  In other words, what are the limitations of QE?

check_circleAnswer
Step 1

After the 2008 great recession, the US economy faced a credit crunch which has to be removed from the US economy in order to take the US economy back to the original growth level. Therefore, the Fed in order to raise the level of the economic activity in the US used the quantitative-easing which is one the form of expansionary monetary policy.

Quantitative easing is a monetary policy where a central bank purchases large-scale asset at the pre-determined amount in order to inject money directly in the economy. However, in the policy the central bank convinces its citizens that it will keep the interest rate very low by giving substantial reserves for as long as is necessary to avoid deflation.

But before preceding to the next step; first we have to know what is QE3? QE3 is known as the third round of quantitative easing which was launched on September 13, 2012 in which the Fed decided to inject a new $40 billion per month of money by using an open-end bond purchasing program. However, from November 12, 2012, there is an upsurge in open-end bond purchasing from $40 billion to $85 billion per month. Now, we have to determine the impact of this QE3 in generating employment in the US. Since, the expansionary monetary policy raises the amount of output production; thereby, able to upsurge the employment rate in the US.

Consider the federal funds market in which the Fed mainly reduces federal funds rate in order to boost up the level of economic activity; therefore, in this case the level of QE reduces the rates at which money supply upsurges in the economy which can be seen from rightward shift in the supply curve by keeping a fraction of reserves.

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Step 2

Generally, it has been argued that a reduction in the federal funds rate makes an expansionary monetary policy more effective by reducing the cost of borrowing; thereby, boost up the investment level by shifting both the aggregate supply and aggregate demand curve rightwards which can be seen from the below diagram:

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Step 3

From this diagram, we can conclude the quantitative-easing as an expansionary policy able to upsurge the level of output growth along with providing a solution that is necessary to eliminate the deflation problem from the economy. Therefore, both the price (P) an...

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