Quantitative Easing: Understanding its Impact and Purpose
Quantitative easing is a monetary policy in which the central bank prints money and buys financial assets to encourage investment and consumption.
An economy’s overview
A country’s economy is healthy when there is stable inflation combined with robust economic growth, low unemployment, and low debt.
The nation’s central bank monitors economic indicators like inflation, employment, real GDP and reacts when these indicators show weakening or overheating economic conditions. They use monetary policy to inject liquidity in the financial system and boost economic activity during recessions or withdraw liquidity during overheating economic activity.
There are three groups of monetary policy tools used by central banks depending on the severity of the economic situation. The ability of a country to use monetary and fiscal policy to boost economic activity depends on the markets’ confidence on that country.
The first group of monetary policy tools (MP1) aims to expand or contract the money supply into the financial system and cause economic growth or contraction by controlling short-term interest rates and the banks’ reserve requirement. Lower short-term interest rates cause a rise in economic activity triggered by rising demand, debt service easing and the wealth effect. During severe economic depressions however, MP1 monetary policy tools are inadequate to boost economic activity.
When short-term interest rates reach the zero bound without succeeding in stimulating the economy recovery the central bank uses quantitative easing.
Quantitative easing aims to stimulate economic activity by forcing investors make riskier investments. The central bank achieves this by printing money and using the proceeds to purchase long-term financial assets such as government bonds. As a result, government bond yields and their expected returns fall, and investors and savers are forced to either use the cash provided to increase consumption or invest in other riskier real or financial assets.
When they invest in real assets or capital investments, this stimulates the economy. However, when they invest in financial assets, the effect is indirect and takes time to show up in the economy via the wealth effect.
Quantitative easing benefits those who own financial assets like investors and savers much more than people who do not, widening the wealth gap.
Quantitative easing is effective when risk premium, which is the excess expected return generated by an investment relative to the risk-free interest rate is high. Over time, the use of quantitative easing to stimulate the economy declines since the extra liquidity of central banks causes asset prices to rise their expected returns to fall and hence the wealth effect to diminish.
When quantitative easing becomes ineffective, central banks move to monetary policy 3 which to print money to purchase new debt issued by governments used to finance increased government spending.
Quantitative Easing Risks
The central bank and government aim to achieve economic recovery by balancing the deflationary forces of austerity, defaults, redistribution of wealth with the inflationary forces of quantitative easing and currency depreciation to bring nominal growth above nominal interest rates. Economic recovery will be accomplished once debt burdens fall relative to incomes
If a developed country with a reserve currency uses quantitative easing recklessly causing a rise in inflation to keep economic growth strong, it will eventually erode its reserve currency as store of wealth and convert a deflationary crisis to an inflationary crisis.
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