Roger Farmer and Pawel Zabczyk.
In a discussion at the Brookings Institution, Ben Bernanke quipped that ‘the problem with Quantitative Easing is that it works in practice, but it doesn’t work in theory’. Bernanke was referring to Wallace Neutrality – a famous result from monetary theory which asserts that the size and composition of the central bank balance sheet has no effect on inflation or employment. In a new working paper we bridge the gap between practice and theory, and we show how, by intervening in asset markets, a central bank can influence both. In our model, that intervention will unambiguously improve economic outcomes. In essence, central banks can use open market operations and trades in risky assets to insure those unable to insure themselves.