policymakers demonstrate

434 Charles Brendon and Giancarlo Corsetti
assets purchased are widely perceived to be risk free – effects come from the
expansion of the central bank’s balance sheet per se – whereas the second is
specifically targeted at problems associated with risky debt. We will consider
both in turn.
Quantitative Easing
What is most remarkable about the widespread experiments with ‘quantitative
easing’ is the absence of a widely-agreed-upon mechanism through which such
a policy should work. Woodford (2012) provides a useful discussion of the main
candidates. These are, first, that an expansion of the central bank balance sheet
is equivalent to an increase in the money supply, and a higher money supply
should – according to various versions of the traditional quantity theory – stimulate
an increase in nominal expenditure in the economy, and hence inflation.
Higher expected future inflation reduces the current real interest rate, stimulating
spending. Second, there is the possibility of a so-called ‘portfolio balance
effect’. If central banks purchase large quantities of long-term assets, issuing
short-term debt (or money) as a counterpart, the relative scarcity of long-term
assets should drive up their price. This lowers the long-term interest rate even
whilst the short-term rate is stuck at zero, potentially stimulating investment
and current consumption. 30
Yet both of these arguments encounter conceptual difficulties. The problem
with the quantity theory channel is that it is unclear why raising the supply
of one zero-interest asset (money) whilst contracting that of another (nominal
bonds, which pay i t = 0 when the zero bound binds) should make any difference
to the economic decisions of consumers. The textbook case for a higher
money supply raising the price level relies on the idea that consumers wish to
hold money only for short-term, transaction purposes. This is because in normal
times bonds dominate money in rate of return. Any increase in the money
supply can only be absorbed if there is an increase in the demand for money for
transaction purposes, and this can occur through an increase in the price level.
But if money and bonds are paying an equivalent rate of return, the logic breaks
down. A higher supply of money can be absorbed without requiring an increase
in transactions demand. This is precisely the case when the zero bound binds.
It follows that there need not be any direct pass-through from the money supply
to the price level.
The difficulty with the portfolio balance channel comes when trying to square
it with modern asset pricing theory, as applied in macroeconomics. Since Lucas
(1978) the conventional approach has been to treat financial assets as claims on
future consumption, priced according to the present value of this consumption
in terms of some numeraire. This delivers asset pricing formulae in which values
reflect market outcomes, but do not have a significant role in determining
them. The price of long-term assets falls in recessions, for instance, because