How Does Quantitative Easing Work?

The act of increasing liquidity and inflation by central banks is known as Quantitative Easing, and its definition may vary depending on different interpretations. The primary objective of QE is to boost the economy of a nation by encouraging businesses and consumers to borrow and spend more. This is achieved by central banks through a market operation that increases liquidity.

QE has been a controversial policy tool, with some experts questioning its effectiveness in stimulating economic growth, while others argue that it has helped prevent financial crises. Nonetheless, many central banks have implemented QE, including the US Federal Reserve, the Bank of England, and the European Central Bank.

Overall, the primary purpose of QE is to provide a boost to the economy by increasing liquidity, and it remains a topic of debate among economists and policymakers.

Basics

When the economy needs a boost, central banks can implement a policy known as Quantitative Easing (QE). QE involves purchasing securities like stocks, bonds, and treasury assets from the government or commercial banks, injecting money into the economy.

To maintain compliance with the fractional reserve banking system, central banks extend new credit and add to member banks' reserve funds. Since new credit is not backed by a physical commodity, QE creates money out of nothing.

QE aims to increase the money supply and stimulate economic activity by keeping interest rates low. This promotes lending for businesses and consumers and fosters confidence in the economy. However, QE is a controversial approach that doesn't always work as intended.

The Bank of Japan is believed by some scholars to have been the first to implement QE in the late 1990s, but this is a subject of debate among economists. Since then, other countries have adopted QE practices in an attempt to mitigate economic difficulties.

What Is the Reason for Using Quantitative Easing?

When conventional banking practices failed to prevent a recession, Quantitative Easing was developed as a solution. The primary objective of QE is to avoid deflation by increasing inflation. Central banks use interest rate adjustments as a primary tool to regulate inflation rates.

When a country's financial activity slows down, the central bank can reduce interest rates to make loans more affordable for banks to extend. Conversely, when spending and credit reach risky levels, a higher interest rate can act as a brake.

Effectiveness of Quantitative Easing

In a note released by the International Monetary Fund (IMF) shortly after the end of the 2008 financial crisis, the effectiveness of QE was discussed as an unconventional monetary policy. The analysis included five major central banks: the US Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada, and the Bank of Japan.

Each institution implemented a unique strategy, but all increased market liquidity. The report indicates that the central banks' interventions were successful and that liquidity was vital in avoiding prolonged economic crisis and financial system collapse.

Despite its success, QE's effectiveness depends on context and strategy. Many economies that have experimented with QE or similar policies have not achieved the desired outcomes. Mismanagement of injecting money into the economy and lowering interest rates may lead to unforeseen and undesirable consequences. Below are some of the potential advantages and disadvantages of QE.

QE's Potential Positive Effects

One of the potential advantages of QE is increased lending by banks, due to their larger pool of funds resulting from central bank asset purchases. Lower interest rates also lead to increased borrowing by consumers and businesses. With more borrowing and lending, more money flows into the economy, leading to greater spending by consumers, who are not interested in keeping money in savings. In turn, this can encourage businesses to expand, sell more products and services, and hire more employees. Therefore, job growth is another potential advantage of QE.

QE's Potential Negative Effects

Some economists warn that QE may only serve as a temporary solution to larger underlying issues, potentially causing economic collapse. There are various possible disadvantages to QE, including inflation. The increased money supply can lead to competition for goods, driving up demand and prices, eventually resulting in hyperinflation if not managed correctly. While commercial banks are encouraged to lend more after receiving central bank funds through QE, there is no requirement for them to do so. Some banks have held onto the funds instead of distributing them. The increased borrowing power of businesses and consumers may lead to an excessive amount of debt, which can negatively impact the economy. The bond market can also be affected negatively by QE policies, which often bring instability and unexpected changes.

QE’s Real Examples

List of Countries and their Central Banks that have used Quantitative Easing:

• Bank of Japan: 2001-2006 and 2012-present (Abenomics). However, QE efforts have not eased their financial problems. The Japanese Yen got weaker against the US dollar, and the cost of imports increased.
• United States: 2008-2014. The U.S. implemented three rounds of QE to address the housing crisis and ensuing recession. While the economy recovered, it's debatable whether it was due to QE or not. A comparison to Canada, which didn't use QE banking practices, reveals no remarkable difference.
• European Central Bank: 2015-2018. The Eurozone has had some hits and misses, with stable inflation, decreased unemployment, and a strong 2017 economy. However, it’s still coping with uninspiring wage growth and rising interest rates.

Conclusion

The effectiveness of QE as an unconventional monetary policy is still being debated. While it may have helped some economies, its risks are a source of concern. So far, the potential risks of QE, such as hyperinflation and excessive debt, have not caused any major problems. However, some countries that have used QE experienced currency instability and negative effects on other economic areas and markets. The long-term consequences of QE remain unclear, and its effects can vary depending on the context.