Long ago, Bernanke (2000) argued that monetary policy retains enormous power to boost production, demand, and employment even at the zero nominal lower bound to interest rates:
The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence…
His argument, however, seems subject to a powerful critique: The central bank expandeth the money stock, the central bank taketh away the money stock, blessed be the name of the central bank. In order for monetary policy to be effective at the zero nominal lower bound, expectations must be that the increases in the money stock via quantitative easing undertaken will not be unwound in the future after the economy exits from its liquidity trap. If expectations are that they will be unwound, then there is potentially money to be made by taking the other side of the transaction: sell bonds to the central bank now when their prices are high, hold onto the cash until the economy exits from the liquidity trap, and then buy the bonds back from the central bank in the future when it is trying to unwind its quantitative easing policies. A Modigliani Miller-like result applies. Consider that:
quantitative easing interventions are in thick and liquid financial markets and so could be easily undone in the future;
after the economy were to exit from its liquidity trap there would then be no forward-looking reason not to undo liquidity-trap quantitative easing; and
the central bankers who would be deciding whether to unwind the past liquidity-trap quantitative easing will be different people than the original central-banking team.
It is then hard to believe that anybody rational would observe $100 billion of quantitative easing and mark up their estimate of the monetary base two decades hence by $100 billion. It is easy to believe that market participants, having to decide what fraction λ of quantitative easing will in fact persist indefinitely, would be likely to settle on a λ much closer to zero than one—and a λ that does not remain constant as the scale of quantitative easing rises.
Thus to make quantitative easing credible--to make Bernanke's argument for the power of quantitative easing true by ensuring that λ near one--quantitative easing has to be associated with other policy measures that make it optimal for the policymakers of the future central bank to maintain the monetary base at its higher post-quantitative easing level.
One such framework is provided by Sargent and Wallace (1981). It is then "fiscal dominance", in the sense of Blanchard (2005), that determines the long-run level of the monetary base. In such a framework, Bernanke is correct if and only if quantitative easing is accompanied by an expansion of the government debt--by the government borrowing money and buying stuff like bridges, highways, biomedical research, and human capital for twelve-year olds--that the central bank in the end shall and must monetize. In fact, in such a framework quantitative easing is then unnecessary: as long as the government expands its debt in a manner such that the central bank in the end shall and must monetize it, the central bank does not need to buy a bond now--but people need to be very confident that it will buy the bonds later, and not unwind the purchase at any time thereafter.
There is a story that Albert Einstein was once asked to explain radio. He supposedly said: "Start with the telegraph. The telegraph is like a very long cat: you pull the tail at one end, and the cat meows at the other. Now radio is exactly like the telegraph--only there is no cat." Likewise, at the zero nominal lower bound, the cat--actual quantitative easing--is not necessary. it is the government budget deficits and fiscal dominance to ensure that ultimately the money stock and the price level will increase and the increases will not thereafter be unwound that is.
References
Ben Bernanke (2000), "Japanese Monetary Policy: A Case of Self-Induced Paralysis?" in Ryoichi Mikitani and Adam S. Posen, eds. Japan’s Financial Crisis and Its Parallels to U.S. Experience (Washington: Institute for International Economics).
Olivier Blanchard (2005), "Fiscal Dominance and Inflation Targeting: Lessons from Brazil", in F. Giavazzi et al. eds., Inflation Targeting, Debt, And The Brazilian Experience, 1999 To 2003 (Cambridge: MIT Press: 0262072599).
Thomas Sargent and Neil Wallace (1981), "Some Unpleasant Monetarist Arithmetic", Federal Reserve Bank of Minneapolis Quarterly Review 5:1 (Fall), pp. 1-17
