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Quantitative Easing - The Basics

Posted in Finance Articles, Total Reads: 4134 , Published on January 18, 2011

Central banks usually set price of money using official interest rates to regulate the economy. These interest rates radiate out to the rest of the economy. They affect cost of loans paid by the companies, cost of household for mortgages and return on saving money. Higher interest rates make borrowing less attractive because taking out a loan becomes more expensive. They also make savings more attractive.

Therefore demand and spending reduces. Lower interest rates have reverse affect.  People borrow more as cost of funds is cheaper which in turn stimulates demand and spending. But interest rates cannot be cut below zero. When official rates become close to zero, the effect they have on regulating the economy becomes muted. Banks still need to make profit and in troubles times’ gap between the official interest rates and interest rates paid by the companies and households can rise because lenders want greater return on the additional risk of granting the loan when times are tough. When interest rates are close to zero, there is another way of affecting the price of money known as quantitative easing.

The aim is still to bring down interest rates faced by companies and household and the most important step in quantitative easing is that central bank creates new money for use in an economy. Only a central bank can do this because its money is accepted as payment by everybody.  Central banks increase the money supply by printing more money in effect increasing credit in its own bank account. It can use this money to buy whatever assets it likes for example Government bonds, equities, houses, corporate bonds or other assets from banks. With the central banks coming in, the price of the assets it buys should rise and yield or the interest rates on that asset will fall. Companies for example with a willing central bank seeking to buy its bonds will be able to pay a lower interest rates when new bonds are issued or existing bonds come to their end of life and need to be replaced. With cheaper borrowing the hope is that central bank will again encourage greater spending putting additional demand in the economy and pulling it out of recession. As the money ends in bank deposits, banks should also find their funding position improved and make them more willing to lend. A side effect would that this new money is expected to raise consumer prices giving people another incentive to buy now rather than later. United States used quantitative easing twice to stimulate their economy which was in tantrums post lehman crises. As the interest rates were very close to zero, United States took the route of quantitative easing to stabilize their economy and increase demand & consumption by giving more money in the hands of people but in a controlled manner.

There are also risks associated with quantitative easing

Central banks can lose money on its purchases. Money that have to be ultimately underwritten by tax payers money either by high future taxation or buy central bank creating more money and risking higher future inflation.

Go too far with creating and spending money which will just destroy value of currency which may result into inflation or hyperinflation. Zimbabwean economy is a prime example of hyperinflation. They just went on printing money which resulted in more than 1000% inflation.

If reduction in quantitative easing destroys confidence in an economy rather than reassurance that the authorities are on the case, it can be counterproductive. That is why central banks cannot use quantitative easing every now and then. If you are not aggressive enough quantitative easing simply won’t change the interest rates in the economy and stimulate demand. The trouble is that since the policy is unorthodox and the situation is dramatic, no one knows how much quantitative easing is too much and how much is not enough.

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