How Can It Work? On the Impact of Quantitative Easing in the Eurozone

How can the quantitative easing (QE) programme launched in March 2015 by the ECB  be  successful  in  the  Eurozone  (EZ)?  What  will  be  its  impact  on  the  member  countries?  And  how  will  it  relate  to  countries'  fiscal  policies?  To  address  these questions, we use a simple extension of the three-­‐equation New Keynesian model. We  modify  the  benchmark  model  in  two  respects:  1)  we  (re)-­‐introduce  an  LM  money  supply  and  demand  equation  to  capture  the  fact  that the ECB operates at the  zero  lower  bound  and  hence  cannot  use  a  standard  Taylor  rule;  and  2)  we  extend the model to a two-­‐country framework. The model supports the ECB official view  that  the  channel  whereby  QE  is  meant  to  operate  is  the  reversal  of   deflationary  expectations.  It  also  highlights  that  instrumental  to  this  goal  is  the elimination of persistent output gaps, both at the EZ and at the country level, and hence  the  reduction  of  country-­‐specific  interest-­‐rate  spreads  -  the  "unofficial"  objective of the programme. We show that QE, if large enough, can succeed for the EZ as a whole. The ECB nevertheless cannot also close individual countries' output gaps,  unless  specific  and  unrealistic  conditions  are  met.  In  this  case  fiscal  accommodation  at  the  country  level  should  also  intervene.  We  show  that  QE  can enhance  the  effectiveness  of  fiscal  policy,  and  therefore  conclude  that  the  coordination of fiscal and monetary policies is of paramount importance.