QE: Greg Ip answers my questions

Are you puzzling over exactly how this “quantitative easing” works? If so, you will appreciate this guest post by Greg Ip for Felix Salmon’s blog:

Are you still confused about quantitative easing, what it is and how it works? I certainly was, and so I asked a genuine expert on the matter — Greg Ip, the author of The Little Book of Economics: How the Economy Works in the Real World — whether he could answer a few questions for me. Greg’s been writing some great blog entries on this subject at the Economist, like the one I linked to this morning, but sometimes you need to take a few steps back to clear up some very basic questions first. Thank you, Greg, for these fantastic answers! If you like them, go buy his book!

FS: Does the Fed print money? If so, how?

GI: Yes, and I’m surprised to see Pragmatic Capitalist dispute this.

It’s true that the Fed is not literally printing the $20 bills that end up in your wallet. As a commenter on your own blog has noted, that’s the job of the Bureau of Printing and Engraving. But money includes both currency in circulation and the reserves that commercial banks keep on deposit at the Fed. By that definition, the Fed is indeed printing it.

Here’s how QE works. The Fed buys a $100 bond from Bank of America. The bond gets added to the Fed’s assets. Bank of America has an account at the Fed. The Fed, with a keystroke, puts a $100 into B of A’s account. Where did the money come from? Thin air. Bank of America can visit its friendly neighborhood Fed branch and withdraw that $100 in the form of bills and coins. So for practical purposes the distinction between currency and reserves is meaningless; the monetary base includes both.

Incidentally, it makes no difference whether the bond belonged to Bank of America, or a customer of Bank of America; the mechanics are identical. When the Fed buys the bond from someone who isn’t a bank (e.g. a primary dealer), the transaction is settled through that person’s bank.

The Fed can also unprint money. Suppose its sells the $100 bond back to Bank of America. It then deducts $100 from B of A’s account at the Fed. The money disappears from existence.

There is much more

BTW, I just bought the Kindle version of The Little Book of Economics: How the Economy Works in the Real World. I did not know of the book – it looks good.