Quantitative Easing (QE) is the purchase of assets by a nation’s central bank from the domestic banks with the aim of improving economic productivity. The most common asset involved in QE transactions in long-term securities. In return, the banks are usually expected to channel the liquidity obtained into the economy through increased and cheaper lending.
In essence, when commercial banks have more money in their vaults, they give out loans with relative ease. Importantly, they give them at reduced interest rates, which incentivize borrowers to take up more loans. When there is more money in the economy, it triggers increased spending and bolsters economic productivity.
Bond purchases are part of the quantitative easing program. By using a small number of bank reserves, the money supply can be increased by purchasing bonds from the market and then lending them to other banks. More money to lend increases the amount of money in circulation, which in turn increases the amount of lending.
Financial markets are often used as the barometer for economic output. When central banks notice widespread panic or gross underperformance by these markets, they quickly swing into action. Once they establish that the economy is in a general decline, they often turn to QE as an intervention measure.
Goals of Quantitative Easing
During times of economic underperformance, many people are often driven by fear of losing their jobs. This often results in reduced spending, which ultimately impacts negatively on the economy. Businesses also feel the impact of widespread frugality when they notice a decline in the number of consumers they have. Eventually, they’ll go into the red and be forced to reduce staff.
The normal course of action for central banks would be to lower interest rates in an effort to improve the economic situation.
With lower interest rates, you earn less on your funds held in a bank, making saving less appealing than spending it. And because interest rates are lower, borrowing money is less expensive, making it easier to finance major purchases like a new home or a new car.
In order to keep the economy thriving and safeguard jobs, people must buy items, and companies must invest money.
The only problem is that interest rates can at times be so low as to be ineffective when additional reductions are needed.
QE has been popular among several central banks because of this. In this approach, spending and investment are both encouraged.
How does QE work?
As central banks like the Fed purchase bonds and other securities, they give banks extra cash, which they can then lend. In addition, the reserve threshold may be lowered to ensure that commercial banks have more room to lend out money.
By reducing the reserve level, banks are able to extend more credit. More money in the country boosts the money supply, allowing interest rates to decline. As mentioned above, when commercial bank interest rates reduce, consumers are more inclined to borrow. The ripple effects of this are then felt by the overall economy because of increased liquidity.
Benefits of QE
- It frees up more money to be injected into the economy through lending. This stimulates increased economic output, leading to the growth of the economy. This is due to the fact that banks now have more money to lend and are more willing to do so to firms and individuals alike.
- QE increases bond and stock prices by stimulating demand for these assets. As a result, banks are able to purchase assets at a lesser price, increasing the profits on those assets. Increased revenue means more money for the bank, which in turn means more money for businesses and consumers.
- QE provides individual consumers as well as businesses and consumers with an incentive to borrow more. Lending by banks increases when they have a larger pool of money available for lending. As a result, more money is available for lending and investing, which helps fuel the economy.
- Economic growth is supported by QE because it helps stabilize financial markets. As a result, QE asset purchases are made on the open market. In turn, this raises asset prices, making more people more inclined to lend money. This contributes to the growth of the economy.
Shortcomings of QE
- QE has the potential to cause asset price bubbles. QE is not intended to cause asset price bubbles. However, if a central bank purchases assets at a low price, it may unintentionally cause asset bubbles. This might be an issue because asset bubbles are bad for the economy.
- There is a possibility that banks will not offer loans to borrowers. This might result in a capital flight, which would have no positive impact on the local economy because it would instead cause investments in emerging markets or other high-potential ventures.
- The import industry does not benefit from the local currency’s depreciation. As a result, both importers and local consumers would face greater expenses as they are forced to spend more to convert the local currency to foreign currency.
- Inflation will occur if the money supply is increased too quickly. If there’s a lot of money floating around, it could lead to riskier investing and higher commodity prices. This happens when the amount of money in circulation does not match the number of products available for sale.
- QE disproportionately benefits society’s upper classes, exacerbating wealth and income disparities.
Does QE always work?
QE works to lower interest rates and promotes the stock market, but it often has less of an influence on the economy as a whole. QE has a mixed effect on the economy, with borrowers benefiting more than savers and investors benefiting more than those who don’t invest.
In addition, after the market has stabilized, QE runs the risk of inflating asset prices, benefiting only a small portion of the population. Also, this approach comes at a high cost in terms of increasing income disparity.
Quantitative easing has proven effective as a monetary policy tool and is likely to continue being used for years to come. Nonetheless, it has some downsides that policymakers and investors should be aware of and institute appropriate actions to offset them.