What is Quantitative Easing?

Hi people, I have been wanting to write this post for a long time because a couple of months ago I read about the financial crisis in Greece, and the proposed bid by the European central bank to resuscitate the economy through quantitative easing. I later learnt that this fell through because Greece was excluded from the European central bank’s quantitative easing program because of its low credit rating; even after the European Central bank increased its monthly purchase of assets from around €13billion to €60 billion until at least September 2016.  This was the first time I was hearing of a quantitative easing program, so obviously, I had to read up on it. So I am writing this post to share my findings. I hope you enjoy.

Quantitative easing is an unconventional monetary policy used by a central bank to introduce new money to the current money supply. The usual process is for the central bank to purchase securities such as government bonds and corporate bonds from commercial banks and other financial institutions in a bid to raise the price of the asset, lower yields, and increase the money supply.

Quantitative easing is usually used when the central bank has lowered interest rates to nearly zero, and the central bank cannot lower it any further.  Quantitative easing might be used by the central bank to stimulate the economy by promoting business activities during a period of recession or depression. Funds are easily accessible to business owners because financial institutions are over whelmed with capital during this period. Lending typically increases, so also does liquidity. A quantitative easing campaign needs to be carefully mapped out because it may lead to high rates of inflation if the increased supply of money is not strictly regulated by the central bank. The idea of it leading to inflation is that since there is an increase in the supply of money and necessarily no increase in the goods for sale, the supply of money would exceed the goods that can be purchased with the said money. This raises the general price level, and a situation where too much money chases too little goods ensues.

The risk of inflation is not the only risk inherent in a quantitative easing campaign. There is a risk that the central bank would buy overpriced securities, thereby needing to create more money in the future to atone for its wasteful spending. This can plunge the economy further into an inflationary period. It would in a way make the central bank’s quantitative easing campaign fruitless, as it would have to implement fiscal policies to curb the inflation; for example increasing taxes in order to reduce the amount of money available for spending. This might discourage businesses and force them to shift base to other countries with favorable tax rates. Then the endless cycle of quantitative easing continues. The central bank initiates another round of quantitative easing to stimulate the economy and encourage new businesses to fill the gap left by previous companies who left for tax friendly countries.

The inflationary risk could be mitigated if the economy outgrows the pace of the increase in money supply caused by the quantitative easing. This may be possible if the increase in money supply spurs an increase in production of goods and services in the economy. In a situation like this, the value of a unit of the country’s currency may end up increasing.

Negative effects of quantitative easing include a dip in investor’s confidence. Investors might read different meanings to a quantitative easing drive, and conclude that the country is in a kind of financial crisis, and then pull out their investments from the country. This makes the whole process counter-productive. Also, an increase in money supply may lead to a decrease in exchange rates relative to other currencies. The reason is that firstly, there might be inflation which makes your exports less competitive in the international market. Foreign countries would shun your goods, and there would be less demand for your currency. This lowers the value of your currency in relation to other currencies. Secondly, an increase in money supply provokes lower interest rates, which reduce the attractiveness of foreigners to save in your country’s bank. Investors may withdraw their money, and exchange it for the currencies of countries with higher interest rates. There would be downward pressure on your currency as people sell it to purchase currencies of other countries they can get high interest rates from.

Recommended Readings

Timothy Taylor., The instant economics: Everything you need to know about how the economy works.

Kjell Hausken., Mthuli Ncube., Quantitative Easing and Its Impact in the US, Japan, the UK and Europe