Quantitative easing and financial stability

The massive expansion of central-bank balance sheets in response to recent crises raises important questions about the effects of such “quantitative easing” policies, both on financial conditions and on aggregate demand (the intended effects of the policies), and their possible collateral effects on financial stability. The present paper compares three alternative dimensions of central-bank policy —conventional interest-rate policy, increases in the central bank’s supply of safe (monetary) liabilities, and macroprudential policy (possibly implemented through discretionary changes in reserve requirements). In the context of a simple intertemporal general-equilibrium model, the paper shows why they are logically independent dimensions of variation in policy, and how they jointly determine financial conditions, aggregate demand, and the severity of the risks associated with a funding crisis in the banking sector. The results suggest that quantitative easing policies may be useful as an approach to aggregate demand management not only when the zero lower bound precludes further use of conventional interest-rate policy, but also when it is not desirable to further reduce interest rates because of financial stability concerns.