How Could QE3 Increase Demand Krugman?

Paul Krugman gives scenario how he feels QE3 could work...

Change in Fiscal Policy Could Affect Housing Recovery

Krugman argues that the Lesser Deppression is a crisis of poor demand.  Boosting the economy is paramount.  Demand can be increased through stimulus or Fed policy.  -that's the theory.

There is an disagreement amongst top officials in the Fed whether QE3 will be effective.  The reasons QE3 is being considered are pretty obvious.  A lack of Demand!

US debt crisis depressed housing prices across the country.  Demand in housing dropped along with construction cutting a large chunk of growth out of the US GDP.  Rising house prices is vital to a healthy recovery in US markets.

Housing Recovery or Housing Bottom?

 

At the beginning of the Lesser Depression, Krugman felt that the Fed can get traction on the real economy through "transmission mechanism".  Housing is the most sensitive or responsive market that the Fed can affect growth.  Why?

Here's what he said:

Because long-lived investments are very sensitive to interest rates, short-lived investments not so much. If a company is thinking about equipping its employees with smartphones that will be antiques in three years, the interest rate isn’t going to have much bearing on its decision; and a lot of business investment is like that, if not quite that extreme. But houses last a long time and don’t become obsolete (the same is true to some extent for business structures, but in a more limited form). So Fed policy, by moving interest rates, normally exerts its effect mainly through housing.

Not this time, however, since housing is deeply depressed and there’s a huge overhang of excess capacity.

 He changed his mind recently:

Since then, several things have happened. First, when I wrote that I don’t think I fully grasped just how big the shortfall in home construction has been, and how long it has gone on; and at this point, of course, it has gone on for another year and a half. So at this point it’s not at all clear that we have an overhang of excess housing capacity; we might even have a shortfall.

This means that we actually can hope that the Fed’s new policy will boost housing as well as operating through other channels, and therefore that it can act more like conventional monetary policy in fostering recovery.

He isn't sure if QE3 will work but at least it provides an environment with low rates battered consumers can use to purchase neighborhood houses.

The stock market moved up strongly after Bernanke announced QE3.  Investors may not believe this is a fix but signals that there may be further fiscal stimulus... or they think this will snowball the housing recovery into a broad, sustained economic recovery!