Introduction
When economic growth slows, and interest rates approach zero, policymakers often resort to quantitative easing. Reduced interest rates are among the few weapons central banks can influence economic expansion. If central banks cannot reduce interest rates further, they will have to boost the money supply purposefully. Government bonds and other securities are purchased by central banks as part of quantitative easing, increasing the money supply in the economy. A further reduction in interest rates and an infusion of liquidity into the banking sector result in more lenient lending terms offered by financial institutions.
For the duration of the COVID-19 pandemic, the Federal Reserve boosted its holdings and employed quantitative easing, which accounted for 56 percent of all Treasury securities issued through the end of the first quarter of 2021. A government can use a fiscal stimulus strategy to increase the money supply. While the Federal Reserve can affect the money supply, the United States Treasury can inject additional funds into the economy through fiscal policy by printing currency and changing tax laws. Quantitative easing can include elements of both monetary and fiscal policy. Here you’ll learn about what is quantitative easing.
How Does Quantitative Easing Work?
Massive purchases of assets are the key to quantitative easing's success. The Federal Reserve has started buying longer-term Treasuries and commercial assets in reaction to the recent coronavirus pandemic. Consider the following (predominantly positive) effects on the economy brought about by the purchase of assets on the open market:
The Fed is currently buying up assets. By creating bank reserves on its balance sheet, the Fed can "print" money out of thin air. With QE, the central bank buys long-term Treasuries on the open market from important financial institutions using newly created bank reserves (primary dealers).
There is an injection of fresh capital. These deals provide financial institutions with more outstanding funds that can be invested, loaned to businesses and consumers, or used to acquire additional assets.
The financial system becomes more liquid. The injection of capital into the economy is meant to forestall financial system issues like a credit crunch, wherein borrowers face increasingly stringent requirements to obtain loans. As a result, we should expect to see the financial markets continue functioning normally.
Borrowers now face even lower interest rates. If interest rates were reduced, more people and firms would take out loans to invest in high-return projects that would stimulate the economy.
Alterations in asset allocations are a common occurrence among investors. As a result of decreased yields on fixed-income assets, investors are shifting their focus to those with more significant potential returns, such as equities. Consequently, the overall stock market may experience more robust gains due to quantitative easing.
Optimism about the economy rises. The Fed has calmed markets and the economy as a whole through QE. Borrowing money, investing in the stock market, hiring more workers, and spending money are ways businesses, and people can assist in stimulating the economy.
Risks of Quantitative Easing (QE)
Inflation
Inflation becomes a more significant threat to the economy whenever there is an increase in the money supply. Since inflation usually lags behind a rise in the money supply by 12 to 18 months, central banks must remain vigilant while the money floods the economy. When both inflation and unemployment are high, we have a stagflationary economy. When quantitative easing fails to provide the desired economic expansion but has the unintended consequence of increasing prices, the result is stagflation.
Restricted Borrowing
Because of this, a central bank like the Federal Reserve has less power to force banks to increase their lending when bank liquidity rises. And the Fed can't force people, companies, or other entities to take on debt or make investments. This results in a "credit crunch" when institutions and businesses withhold lending due to apprehension about the economy.
Currency That Has Lost Value
Currency depreciation is a possibility when the money supply expands, which could result from quantitative easing. Although domestic producers can gain from a depreciating currency because it makes their products more competitively priced on the international market, a weakening currency makes imports more expensive, which drives up production costs and consumer prices.
Conclusion
By purchasing assets in open market operations, central banks like the Federal Reserve in the United States have implemented a programme known as quantitative easing to increase the money supply and promote bank lending and investment. The impact of global adoption of quantitative easing tactics on national economies is still up for debate.
