What is "Quantitative Easing" Anyway?
Recently, the news is abuzz with the term "quantitative easing." What is it anyway and how does it affect you?
Quantitative easing is the act of central banks injecting the economy with cash in every conceivable way. In response to the financial collapse and the ensuing recession, central banks around the world used every tool at their disposal to increase the money supply. The US Federal Reserve has been extremely proactive in coming up with innovative solutions to increase the amount of capital available to banks, increase the money supply, and prevent deflation. These "creative" solutions fall under the umbrella term "quantitative easing," although the US Federal Reserve has attempted to distinguish its strategy by phrasing it as "credit easing."
Basically, quantitative easing is a monetary policy where central banks "print" money and introduce this newly created wealth into the money supply by purchasing securities on the open market. The banks from which these securities are purchased then have additional capital beyond their reserve requirements that they can loan, invest, or horde for themselves. Quantitative easing is usually employed when the federal funds rate is at or near 0% because there is no possible way to lower this rate.This results in the Federal Reserve expanding its balance sheet. In the past couple years, quantitative easing has often been in the news as the Federal Reserve agreed to buy billions of dollars worth of government bonds, mortgage bonds, and other securities.
The intended short-term result of quantitative easing is to increase the money supply and stimulate the economy. By purchasing government bonds on the open-market, the Federal Reserve can lower interest yields, which in turn lowers the interest on new debt, potentially encouraging companies and individuals to consume more credit and increase spending.
Conversely, quantitative easing lowers the deposit rate, or the rate banks pay depositors. A lower deposit rate reduces the benefits of holding savings, and encourages depositors to consume their deposits or seek other investments. The end result of quantitative easing is intended to benefit consumers. Decreased borrowing costs and an expanded money supply is supposed to increase demand and consumption. Once demand starts increasing, confidence should return to businesses and hiring will resume.
Modern economic theory argues that deflation is one of the worst possible economic outcomes and quantitative easing is supposed to prevent that. The idea being that if deflation takes hold and prices continue to fall, consumers will delay purchases, assuming that prices will be cheaper in the future. Delaying purchases decreases demand and leads the economy on a downward spiral. Furthermore, quantitative easing reduces the pressure on banks by increasing their available capital and increasing demand for loans.
The biggest risks associated with quantitative easing can occur when the folks in charge introduce too much cash with their policies and hyperinflation results. If there is a great increase in the money supply, then real goods, commodities, and services can drastically increase in price while savings and the value of the dollar are destroyed. Creditors will lose real return on their investments and the effect on the country's credit could be disastrous. These problems can be exacerbated by politicians who see government debt being purchased and use the opportunity to increase government spending without increasing taxes.
The bottom line is that quantitative easing can be a double-edged sword. In the case of Japan, quantitative easing did not work and deflation ensued for years. This could also happen in the United States. What do you think? Should central banks around the world continue their policy of quantitative easing to battle deflation and spur borrowing? Have you taken advantage of the lower interest rates?
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