What is Quantitative Easing?

B is correct. When the Fed implements QE by purchasing large quantities of long-term bonds, it increases demand for these securities in the market. This increased demand drives bond prices up and yields down (inverse relationship). David's long-term government bond holdings would likely experience price appreciation in the short term as the Fed's purchases support the market.

A is incorrect because it misunderstands the supply-demand dynamic. The Fed is a major buyer adding demand, not supply. When a large buyer (the Fed) enters the market purchasing bonds, it drives prices up, not down. C is incorrect because QE specifically targets long-term securities, not short-term ones. Unlike conventional open market operations (which target short-term rates), QE is designed to lower long-term interest rates, typically when short-term rates are already at or near zero. D is incorrect about the direction of yield changes. QE pushes yields lower, not higher. While QE can raise long-term inflation concerns, the immediate market impact is lower yields as the Fed purchases drive up bond prices.

B is correct. QE is an unconventional monetary policy tool typically used when conventional policy (lowering short-term rates through regular OMO) has been exhausted because rates are already at or near zero. QE involves massive purchases of longer-term securities (10-year, 20-year, 30-year Treasury bonds and MBS) to directly lower long-term interest rates and inject liquidity into the financial system. The scale is much larger than daily OMO operations.

A is incorrect because both QE and conventional OMO involve purchasing securities when the Fed wants to ease policy. The difference is in the type, scale, and maturity of securities purchased. C is incorrect because both QE and OMO are conducted by the Federal Reserve (specifically the FOMC and the New York Fed trading desk), not the Treasury. The Treasury issues debt; the Fed manages monetary policy. D is incorrect about the securities purchased. QE primarily focuses on Treasury securities and agency mortgage-backed securities (MBS), not corporate bonds. Some crisis programs have included corporate bond ETFs, but the core QE purchases are Treasuries and MBS.

B is correct. QE programs targeting Treasuries and MBS directly benefit long-term government bonds and mortgage-related securities. The Fed's purchases add demand for these specific securities, pushing their prices up and their yields down. Because the Fed is buying exactly these securities, they are the most direct beneficiaries of the announced program.

A is incorrect because QE targets long-term securities, not short-term Treasury bills. Short-term rates are already managed through conventional OMO and the federal funds rate. QE is typically implemented when those conventional tools affecting short rates are exhausted. C is incorrect because Fed QE purchases focus on U.S. Treasury securities and agency MBS, not international bonds. While global liquidity effects may indirectly impact emerging markets, they are not direct beneficiaries of Fed purchases. D is incorrect because standard QE programs focus on Treasuries and agency MBS, not corporate credit. While lower overall rates may indirectly benefit corporate bonds through improved financing conditions, the Fed is not directly purchasing high-yield bonds or leveraged loans in this scenario.

C is correct (the exception). QE does not reduce the Fed's balance sheet. It expands the balance sheet massively. When the Fed purchases securities through QE, those assets appear on the Fed's balance sheet, and the Fed creates reserves (credits banks' accounts) to pay for them. This is balance sheet expansion, not reduction. The opposite process (selling assets to shrink the balance sheet) is called quantitative tightening (QT), not QE.

A is accurate: QE involves large-scale purchases of longer-term Treasury bonds and mortgage-backed securities to directly lower long-term interest rates, typically when conventional policy has little room left. B is accurate: QE is an unconventional policy tool typically used when conventional tools (lowering the federal funds rate) have been exhausted because short-term rates are already at or near zero. The zero lower bound leaves little or no room for further rate cuts. D is accurate: the primary goal of QE is to stimulate the economy by making long-term borrowing cheaper (mortgages, corporate bonds, etc.), supporting asset prices, and encouraging banks to lend rather than hold reserves.

C is correct. Statements 1, 2, and 4 are accurate.

Statement 1 is true: Moving from QE (adding liquidity, expanding balance sheet) to QT (removing liquidity, shrinking balance sheet) is a shift from expansionary to contractionary monetary policy. QE stimulates; QT restrains.

Statement 2 is true: When the Fed stops purchasing long-term bonds and allows its holdings to mature without replacement, it removes a major source of demand from the bond market. This reduced demand (the Fed stepping away as a buyer) puts upward pressure on yields and downward pressure on bond prices. Runoff is not an outright sale, but shrinking the Fed's holdings leaves more bonds for private investors to absorb.

Statement 3 is false: The money supply decreases, not increases, during QT. When QE securities mature and the Fed doesn't replace them, the Fed's balance sheet shrinks and bank reserves decline. This removes money from the banking system, contracting the money supply. QT is designed to reduce liquidity, not increase it.

Statement 4 is true: The Fed typically shifts from QE to QT when economic conditions have improved sufficiently and inflation risks emerge. QT is a policy normalization tool used when the Fed wants to tighten financial conditions to prevent overheating or combat rising inflation. The shift signals the economy no longer needs emergency support.