The Power of Quantitative Easing : Liquidity Channel vs Interest Rate Channel

This paper disentangles the effectiveness of quantitative easing (QE) into two channels: Liquidity (injecting liquidity into the market) and interest rate (twisting the term yield). Through a general equilibrium model with household heterogeneity and financial friction, I demonstrate that they affect the power of QE by altering the liquidity and interest rate channel asymmetrically. Based on the model and calibration, I conclude that the effect of liquidity channel to stimulation power of QE on output is approximately 1.5 times larger than that of interest rate channel. Meanwhile, the complementarity between household heterogeneity and financial friction plays a vital role in determining the power of QE. In the end, I empirically identify these two channels and support the quantitative result by proposing a new instrument variable in IV-VAR