In a lecture given to George Washington University students today, Federal Reserve Chairman Ben Bernanke presented a simple explanation of how long-term asset purchases actually work to stimulate the economy.
His explanation is key to understanding whether or not this was the best course of action for the U.S. at the time.
Bernanke noted that the Federal Reserve traditionally owns a significant quantity of long-term asset purchases, and owned about $800 billion before the crisis.
According to his explanation, here's how the process worked:
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The Fed began purchasing Treasuries and government-sponsored enterprise (GSE) securities, making them more difficult for commercial banks to obtain.
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In doing so, the Fed drastically increased the demand for Treasuries, so bondholders could raise the price they charged for the securities in comparison to the return.
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This had the effect of reducing interest rates without direct monetary policy, since interest rates are closely related to the rate of return on Treasuries.
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Low availability drove investors to put money in corporate bonds, thus stimulating the economy.
To keep in mind, this chart demonstrates the massive scale of this program.
Click for larger image.
Further, Bernanke rebuffed analyst descriptions of how the Fed "printed money" in order to finance these asset purchases. Instead, the Fed credits "the accounts that commercial banks hold with the Fed [which are] part of what's called the monetary base," but not part of the cash supply.
In order to offset asset purchases and normalize its balance sheet, the Fed simply ticked up the number of assets that commercial banks held with the Fed. Therefore, the Fed did not add to the cash supply, but it did some behind-the-scenes balance sheet manipulations that had the effect of expanding the money in the system.
This chart breaks down the liabilities side of the Fed's balance sheet:
Click for larger image.
These were inflationary measures, but at the time the Fed was far more worried about deflation than inflation, so on the whole did not consider this a concern.
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