How can the Fed precommit to a permanent expansion of the money supply ?

A challenge for monetary authorities in a liquidity trap is that it is hard convince people that they won’t reverse expansionary policies as soon as the economy leaves the liquidity trap. The other problem is that they can’t do much other than affect expectations while the economy is in a liquidity trap. This suggests that they can’t do much at all. This argument assumes model consistent expectations (aka rational expectations) but that doesn’t mean it is totally wrong.

My view has been that the key word is “Much” and that the monetary authority can also bear risk. In particular, I think that the Fed can and should bear mortgage default risk by buying mortgage backed securities.

The disadvantage of this approach is that, if house prices and/or GDP tank, then the Fed’s balance sheet won’t balance. It would not be possible for the Fed to retire as much of its obligations as it might choose, because they are worth more than its assets.

This disadvantage is an advantage. It means if things turn out to be worse than expected, then the Fed will not be able to reverse the expansion of the money supply. This means that, if the Fed loses on its investments, then, when the economy recovers, there will be higher than target inflation — the Fed would like to reduce the money supply but won’t be able to do so.

I think this is exactly what the economy needs. The disadvantage of Fed purchases of risky assets is, in fact, a huge advantage.

If the Fed wins its bet, we win (it would transfer the profits to the Treasury). If the Fed loses its bet, we win (it would automatically commit to high inflation even if when the inflation comes the Fed wants lower inflation).

OK Ken, the ball’s in your court.

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