Saturday, June 29, 2013

What is Quantitative Easing?

Quantitative easing has begun.
Quantitative easing has stopped.
The Federal Reserve makes a statement on quantitative easing.
The IMF expresses concern regarding quantitative easing.
QE is affecting all currencies.
Signal to the end of QE led to stock markets plummeting.

But wait, what is quantitative easing exactly? 

Quantitative easing has always been a favourite with the news papers and news channels, but confuses the common man.
Let us try to understand and grasp this concept.

What is QE?
QE is an unconventional monetary policy of the central bank of the country to stimulate liquidity in the economy. Just like CRR and interest rates are reduced by the central bank to increase loans and thus stimulate spending, QE is a similar policy to achieve the same purpose. QE involves purchasing of government bonds by the central bank from commercial banks or other private institutions like pension funds or insurance companies in order to increase liquidity in the economy. QE was first performed by the Bank Of Japan, and has now been adopted by the Federal Reserve and the Bank Of England.

When is QE undertaken?
QE is undertaken only when the conventional monetary policies prove ineffective to stimulate liquidity in the economy. For e.g., when the interest rates have been dropped to a point below which they cannot be dropped further, the central bank has to resolve to QE to further solve the problems of the economy.

Where does the money come from to buy government bonds?
There is a misconception that QE involves printing money. Such transactions are performed electronically. For example: Bank ABC’s assets consist of 30 bonds, 20 loans and 60 reserves. The assets of the central bank consist of 80 bonds. When the central bank purchases all the bonds of the Bank ABC, the total bonds of the central bank become 110(80+30). The change in Bank ABC’s balance sheet will be to swap the reserves with the bonds. Thus Bank ABC will have 0 bonds and 90 reserves (60+30).

How this mere swapping of bonds with reserves affects the economy?
As the reserves with the banks increase, their capacity to lend loans increases simultaneously. Thus, the banks lend more loans, stimulating liquidity in the economy. This will pull up the inflation rate. For example, the Bank of England is practising QE to achieve an inflation rate of 2%.
If more loans are injected in the economy and as liquidity increases, people tend to set up new businesses and expand existing ones, increasing employment. For example: Federal Reserve has planned to continue QE3 till the economy achieves an unemployment rate of 7%.
When the central bank buys government bonds from private institutions like insurance companies and pension funds, they get more money, which they are likely to invest in other companies rather than buying more bonds. This is because, the central bank’s demand of government bonds will push up their prices, reducing their yield, making bonds an unattractive investment. Thus, the companies will prefer to invest in other companies or expand their own businesses with this extra money rather than buying more government bonds. This will further expand economy and boost employment rates.

What are the negative impacts of QE?
QE increases inflation, which if goes out of hand, can be pretty difficult to control. It also puts pressure on the consumer, who faces the brunt of rising prices. The value of the home currency also drops because of the increase in supply of the currency.

Thus, quantitative easing is indeed an unconventional monetary policy, which should be resorted to only when the other policies become ineffective. The duration and the extent of QE must be carefully determined to prevent the negative impacts of the same.

|Simran Ahluwalia|

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