What is Quantitative Easing?
Quantitative easing (QE) is a non-traditional monetary policy in which a central bank buys out the market government securities or other securities to increase the supply of money and promote lending and investment.
If short-term interest rates are at or near zero, normal open market operations, which target interest rates, are no longer effective. Therefore, a central bank can target defined amounts of assets to be purchased instead. Quantitative easing raises the money supply by buying assets with newly formed bank reserves to provide further liquidity to the banks.
Understanding Quantitative Easing
To conduct quantitative easing, central banks buy government bonds and other securities to increase the money supply. Accelerating money supply is similar to increasing supply of any other asset—it reduces the cost of money. A lower cost of money means lower interest rates and better conditions for banks to lend. This technique is used when interest rates reach zero, at which stage central banks have fewer tools for controlling economic growth.
Fiscal policy of government spending may be used to further expand the money supply if quantitative easing itself loses effectiveness. Indeed, quantitative easing also can blur the line between monetary and fiscal policy if the purchased assets consist of long-term government bonds issued to finance counter-cyclical spending on the deficit.
Drawbacks of Quantitative Easing
When central banks increase the supply of currency, that can cause inflation. In a worst-case scenario, the central bank could cause inflation via QE, triggering a period of so-called stagflation without economic growth.
While most central banks are created by the government of their countries and involved in some regulatory oversight, central banks cannot force banks to increase lending or force borrowers to look for loans and invest. If the increased money supply does not work through the banks and into the economy, QE may not be effective except as a deficit spending facilitator (i.e. fiscal policy).
