Permanent versus temporary monetary base Injections: Implications for past and future Fed Policy

Despite the Federal Reserve's use of quantitative easing (QE) programs, the U.S. economy experienced one of the weakest recoveries on record following the Great Recession. Not only was real growth disappointingly low, but even nominal growth over which monetary policy has more control was feeble. Why did QE fail to stimulate robust aggregate demand growth? This paper argues the answer is that the Federal Reserve could not credibly commit to a permanent expansion of the monetary base under QE. Both quantity theoretic and New Keynesian models show, however, that a permanent expansion of the monetary base is needed to spur aggregate demand growth at the zero lower bound (ZLB). The Federal Reserve's inability to do so meant its QE programs got consigned to ‘irrelevance results’ of Krugman (1998) and Eggertson and Woodford (2003) and were never going to spark a strong a recovery. Going forward, this inability to commit to a permanent expansion of the monetary base at the ZLB will continue to weigh down on the effectiveness of Fed policy. As a result, this paper calls for a new monetary policy regime of a NGDP level target that is backstopped by the consolidated balance sheet of the government.