Quantitative Easing

DEFINITATION

Quantitative easing is a massive expansion of the open market operaton of a central

bank. It’s used to stimulate the economy by making it easier for businesses to borrow
money. The bank buys securities from its member banks to add liquidity to capital
markets. This has the same effect as increasing the money supply. In return, the
central bank issues credit to the banks' reserves to buy the securities.
PROCESS
 Quantitative easing affects the economy through several channels:

• Credit channel: By providing liquidity in the banking sector, QE makes it easier and cheaper for banks to
extend loans to companies and households, thus stimulating credit growth. Additionally, if the central
bank also purchases financial instruments that are riskier than government bonds (such as corporate
bonds), it can also increase the price and lower the interest yield of these riskier assets.

• Portfolio rebalancing: By enacting QE, the central bank withdraws an important part of the safe assets
from the market onto its own balance sheet, which may result in private investors turning to other
financial securities. Because of the relative lack of government bonds, investors are forced to "rebalance
their portfolios" into other assets. Additionally, if the central bank also purchases financial instruments
that are riskier than government bonds, it can also lower the interest yield of those assets (as those assets
are more scarce in the market, and thus their prices go up correspondingly).
•
• Exchange rate: Because it increases the money supply and lowers the yield of financial assets, QE tends to
depreciate a country's exchange ratre relative to other currencies, through the interest rate mechanism.
Lower interest rates lead to a capital outflow from a country, thereby reducing foreign demand for a
country's money, leading to a weaker currency. This increases demand for exporters and directly benefits
exporters living in the country.

• Fiscal effect: By lowering yields on sovereign bonds, QE makes it cheaper for governments to borrow on
financial markets, which may empower the government to provide fiscal stimulus to the economy.
Quantitative easing can be viewed as a debt refinancing operation of the "consolidated government" (the
government including the central bank), whereby the consolidated government, via the central bank,
retires government debt securities and refinances them into central bank reserves.

• Signalling effect: Some economists argue that QE's main impact is due to its effect on the psychology of
the markets, by signalling that the central bank will take extraordinary steps to facillitate economic
recovery. For instance, it has been observed that most of the effect of QE in the Eurozone on bond yields
happened between the date of the announcement of QE and the actual start of the purchases by the ECB.
 Reasons the Fed Uses Quantitative Easing

The Federal Reserve uses quantitative easing for a variety of reasons:

• Foster maximum employment- The Fed argues that money printed through the
QE program can be used to help create new job for america since businesses
should end up with more cash on hand to finance new hirings. However, critics
argue that any actual employment benefits are only temporary.
• Encourage lending- The general premise behind this claim is that central banks can
reduce long-term interest rates by buying treasuries. In providing financial
institutions with more cash, these institutions should be more willing to lend out
money at lower rates. Such loans then act to further stimulate the economy
through higher consumer spending and business development.
• Encourage borrowing- Low interest rates tend to encourage increased borrowing.
Although this can help stimulate the economy, some argue it also has the
tendency to encourage customers and businesses to take on unnecessary debt. At
the same time, some level of debt and leverage is essential to the growth of any
economy, especially one in dire straits.
• Increase spending- The theory is that as more money enters the economy,
consumers will have more to spend. This will in turn increase company profits and
create more jobs, helping stimulate the stock market. Ultimately, these factors
should result in newfound consumer confidence and an economic recovery.
• Complement low interest rates- Another tool used to stimulate the economy is
the federal funds rate. By setting this rate low, the Fed can effectively encourage
lending.
 Risks of Quantitative Easing

Quantitative easing has come under fire for multiple reasons:

• It drives inflation much higher- This is the biggest concern around quantitative easing. As more money
circulates through the economy, prices rise.
• It creates havoc with international trade- Newly printed money can be used by the government and
consumers to import new goods and services from other countries. These goods and services are more or
less coming in for free.
• Threat to the U.S. dollar_ Many countries get frustrated with attempts at currency manipulation like
quantitative easing. They feel that these practices reflect an inability by the country to generate real
growth and to honor debts. For example, other countries have become weary of lending the U.S. more
money. Also, the status of the U.S. dollar as the world reserve currency is in jeopardy, likely because of
quantitative easing.
• Benefits don’t outlast QE programs- When the central bank stops printing money, the recovery often gets
put on hold, or worse, begins to reverse. Although the hope is that new consumer confidence will inspire a
real recovery, many feel these programs are only a short-term fix. This effect is exhibited by the fact that
stock markets often fall when it is announced or speculated that the quantitative easing program will be
brought to an end.
• Encourages debt- Another key worry about quantitative easing is that the increased money supply and
low interest rates encourage additional borrowing by both consumers and businesses. While some debt
can help stimulate an economy, wanton loans and excessive debt can further exacerbate an already fragile
one. Moreover, quantitative easing can lead to an increased government deficit as was the case with the
U.S. in 2010 when it actually reached its debt celling.
•