The theory (and rational) behind Quantitative Easing explained

mirco balatti

The primary channel through which LSAPs appear to work is the risk premium on the
asset being purchased. By purchasing a particular asset, the Federal Reserve reduces the amount
of the security that the private sector holds, displacing some investors and reducing the holdings
of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held
by the private sector. In order for investors to be willing to make those adjustments, the
expected return on the purchased security has to fall. Put differently, the purchases bid up the
price of the asset and hence lower its yield. This pattern was described by Tobin (1958) and is
commonly known as the “portfolio balance” effect.
Note that the portfolio balance effect has nothing to do with the expected path of shortterm
interest rates. Longer-term yields can be parsed into two components: the average level of
short-term risk-free interest rates expected over…

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