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The effects of easy money

Easy-money policies are used to stimulate bank lending and spending by consumers and businesses at times when the economy is in a recession and unemployment is unusually high. If the easy-money policies cause aggregate demand to increase, real output will rise more rapidly and unemployment will decline.

These beneficial effects of easy money are, however, not automatic. If the economy is in quite severe recession and expectations regarding the future are gloomy, consumers and businesses may be reluctant to borrow and spend money. Also, the banks may choose to hold some excess reserves rather than make loans that might prove risky due to poor economic conditions. Thus, easy money merely increases the banks’ reserves and makes more loans possible; it does not automatically create money and boost aggregate demand. This problem has been likened to “pushing on a rope,” which suggests that easy money by itself may not always be sufficient to lift the economy out of a recession. For this reason, many people believe that easy money should be combined with federal budget deficit, which can provide a more direct boost to aggregate demand and can thereby start the economy on its way toward recovery.

When easy money does generate higher aggregate demand, the results are not totally beneficial: a side effect of the increased total spending may be more rapid inflation. While the reduced unemployment from the easy money policies may make some additional inflation acceptable, this side effect does place a limit on the use of easy money.

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