It’s all about expectations. A nebulous concept, to be sure, but one that’s not beyond influencing macro outcomes with some control via monetary policy. To what extent? To what end? Ideally, it runs like this, as per Professor David Beckworth: “Here is why I think QE will pack an economic punch, if done correctly. The expectation of permanently higher prices will cause cash-flushed firms, households, and other entities to start spending more today. Right now there is an excess money demand problem that could be stemmed by meaningfully changing the inflation outlook.”

Beckworth continues…

Those folks and entities hoarding money would on the margin face an greater incentive to start spending given an significant increase in inflation expectations. (Yes, many households with weakened balance sheets are deleveraging and saving more. However, the rise in saving by these troubled households–by paying off debt, cutting back on spending, or buying other assets–should lead to more money for other non-troubled households unless the money is being hoarded somewhere else. Maybe the non-troubled households choose to sit on their money, maybe the creditors to whom the troubled households send their money are sitting on the money, or maybe it’s the creditors’ creditors that are sitting on the money. The details are not important, what is important is that somewhere in the economy there is an excess demand for money right now that is not being met by the Fed.)

Now assume the Fed does indeed address this excess money demand problem with QEII. Given sticky wages and prices, this pickup in spending (i.e. drop in money demand) will translate into real economic gains. This will encourage banks to start lending more as they see better credit risk going forward while the improved economic outlook encourages firms and households to start borrowing more too. On top of that, the higher expected inflation will drop the real interest rate and encourage more interest-sensitive spending. Next, we could consider how the pick up in asset prices might have a wealth effect on consumption. The pickup in asset prices could also improve troubled households balance sheets and thereby enhancing their access to credit. Finally, further depreciation of the dollar may spur exports. Bottom line is that there are multiple channels through which QE could work.