When the economy takes a hit, governments have a range of strategies they can try to get things moving again. One example is quantitative easing, a tactic used to increase money supply in times of crisis. Learn more about how quantitative easing works in our guide.
Understanding quantitative easing
When a central bank purchases long-term securities from the open market, this is called quantitative easing. Within the U.S., only the Federal Reserve can use this monetary policy tool. By purchasing securities, the Fed gives the market an influx of new money. This results in a reduction in interest rates, making it easier for consumers to borrow money and positively impact economic growth.
How does quantitative easing work?
Central banks like the Federal Reserve can lower short-term interest rates directly as part of normal open market operations. However, once these rates have already reached zero, an unconventional monetary policy like quantitative easing is the next step. By purchasing assets to increase money supply, banks have more liquidity to encourage investment and lending.
Here’s a breakdown of how it works:
The Federal Reserve purchases securities or assets like bonds from its member banks.
It makes these purchases in cash, which gives the bank reserves a boost.
The banks have more cash on hand for lending and investment.
The Federal Reserve can also lower the banks’ reserve requirement, or the proportion of funds kept vs. funds lent out.
By lowering the reserve, banks are free to lend more money.
With more money going out into the economy through lending, interest rates fall.
Lower interest rates encourage consumers to borrow and spend, stimulating the economy.
As you can see, when answering the question of “how does quantitative easing work?” this policy operates on several levels. It not only increases the supply of money in circulation, but reduces interest rates and encourages spending.
Economic impact of quantitative easing
In addition to its impact on the reserve and interest rates, there are a few ways that Federal Reserve quantitative easing works to stimulate the economy.
It reduces bond yields: When the fed buys government bonds as part of quantitative easing, it increases their demand. This keeps yields low.
It makes borrowing more affordable: Quantitative easing reduces consumer debt rates including mortgages as well as car loans and long-term financing for goods. It’s also easier for businesses to expand with lower costs of borrowing.
It invites foreign investment: As money supply increases, currency value decreases. With a weakened U.S. dollar, foreign investors jump at the chance to purchase U.S. stocks and bonds. This gives an infusion of cash to the economy.
Quantitative easing and inflation
There are many potential benefits to Federal Research quantitative easing policies, but what about the downsides? One issue to consider is the relationship between quantitative easing and inflation. As the Fed’s balance sheet increases in value to its acquisition of government-backed securities, it can potentially lead to inflation.
We’ve mentioned above that a weakened U.S. dollar encourages foreign investment, but when currency values drop, it also means that a dollar buys less than it used to. In other words, it causes inflation. To counteract this effect, the Fed can sell off its assets when inflation starts to rise. It’s a delicate balancing act to keep the economy on track.
Quantitative easing timeline and examples
Quantitative easing is a relatively new fiscal policy. To trace the quantitative easing timeline, we must first look back at Japan’s response to the Asian Financial Crisis of 1997, which caused a long-term economic recession. Japan’s central bank was the first to use quantitative easing in 2001. The Bank of Japan purchased a high quantity of securities including stocks and private debt, pivoting away from government bonds. Unfortunately, in this case the plan was unsuccessful.
Following the financial crisis in 2008, the Swiss National Bank followed a quantitative easing policy by purchasing a high volume of assets. In fact, the bank owned so many assets that it exceeded Switzerland’s annual economic output, pushing interest rates below 0%.
The U.S. has pursued this expansionary strategy on several occasions, most recently in 2020 to mitigate the adverse effects of the COVID-19 crisis. The Federal Reserve announced its plan to purchase up to $700 billion in assets to boost the economy’s liquidity.
The bottom line
Quantitative easing is an at-times controversial monetary policy. When successful, it can pull countries out of economic recession and increase confidence in banking institutions. At the same time, it can cause asset bubbles and inflation if left unchecked. To work as intended, banks must be willing to increase lending and borrowers willing to accept risk.
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