Ramesh Ponnuru sent me the following article from the Richmond Fed:
“I feel like a lazy bum,” lamented economics blogger Scott Sumner in a recent post. ”This morning Ben Bernanke created $250,000,000,000 in new wealth before I’d even finished breakfast.” The Bentley University professor argued that the Fed chairman’s speech that morning had led to about a half percent increase in stock prices worldwide based on the hopes it created for further monetary easing. With it came a windfall for equity investors.
When the Fed injects money into the economy, the effects are not spread evenly. The first point of impact is the banking system, where the Fed trades newly created money for assets. The infusion of cash causes financial institutions to bid down lending rates, which pushes down other lending rates in the economy and, the Fed hopes, stimulates the economy as a whole.
This is technically correct, but it creates a misleading impression. I notice that many commenters believe it matters where the money is injected. Not true. If the Fed injected the money into the computer software industry by buying T-bonds from Microsoft, the impact would be essentially identical. Microsoft would probably take the cash and deposit it in the bank the same day. But even if they didn’t, even if they spent the money on stocks, the impact on interest rates would be identical.
Even before the Fed existed, easy money would often depress short terms rates. For instance, a sudden discovery of gold would depress interest rates under the gold standard. This is because monetary policy has nothing to do with credit, it’s all about changes in the stock of the medium of account (MOA.) When you increase the stock of MOA then prices should increase in proportion. But because prices are sticky in the short run, people temporarily hold excess cash balances (or excess gold balances under the gold standard.) Since the nominal interest rate on the MOA is zero, the nominal interest rate on financial investments is the opportunity cost of holding the MOA. That rate must fall until people are willing to hold those excess cash (or gold) balances. This is shown at point B on the graph below. Then prices and NGDP adjust in the long run, and you go to point C: