Quantitative Easing Explained and how it works

Quantitative easing is a form of a monetary policy, often used by central banks in order to raise the money supplies during critical times when either the interest rates or interbank lending rates are close to zero. Such situations arise when there is either a low inflation or deflation. In such cases reducing the interest rates even further isn’t enough to maintain the money supplies; thus quantative easing is used.

When the Central banks cut the interest rates it is seen as an action to encourage lending. Lower interest rates are usually indicated by an increase in consumer spending.

Over a period of time, Central banks do come face to face with a situation where they are not able to cut the interest rates any further, by making use of Quantitative easing, they (Central banks) inject money into the economy. This phenomenon of injecting money directly into the economy is known as Quantatitive easing.

In order to raise the money required for Quantitative easing, Central banks purchase government and corporate bonds. The sellers of these bonds then get the cash required and thus new supply is created.

Quantitative easing can often be confused with printing new money. In today’s age, most of it is done electronically. In other words, there is no need to ‘print’ actual currency although critics say it (Quantitative easing) more or less is similar to the same (printing of money).

Quantitative Easing or QE started gaining prominence since early 2007 when the global crisis started.

Quantitative Easing Explained

Quantitative easing is executed by the banks starting a reverse bond auctions. In a reverse bond auction, the sellers compete against each other and thus the prices are pulled down. By way of Quantitative easing banks basically lend money to businesses and individuals thus creating an activity in the economy. In the same note, Quantitative easing also affects the cost of borrowing. By purhcasing bonds, the supply of the bonds in the markets is reduced thus increasing the demand for newer bonds while reducing the rate of interest for borrowing loans.

By doing so, the short term interest rates are reduced which in turn has an affect on the long term borrowing costs as well which is commonly used by businesses and bank mortgages.

In this way, the credit growth picks up thus enabling businesses to borrow loans indirectly stimulating the economy.

Quantitative easing has been used by the US, UK and the Eurozone in the wake of the financial crisis. The ECB for example conducts the 1 year/3 years refinancing options, known as the LTRO which is a form of Quantitative easing.

When talking about Quantitative easing, the terms QE1, QE2, QE3 are often used in the same breath. The QE and the number signifies the number of times QE has been used. QE3 hints at proposals for another round of quantitative easing following QE2.

Quantitative easing must be used by banks after a thorough analysis. If for example the amount of easing is overestimated, it would result in higher inflation as a result of excessive money that is made available via QE.

Quantitative Easing Explained
Quantitative Easing Explained in Simple Terms

Quantitative Easing – To Summarize

  • QE is used to create money in order to boost an economy’s money supply
  • Quantitative easing helps to maintain stability of prices and a currency’s value
  • QE is used when the economy is faltering and any past monetary policies (interest rates) implemented do not make any impact
  • Central banks make new money and use it to purchase assets such as government bonds
  • The new money is now infused into commercial bank reserves

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