Quantitative Easing - explained

Quantitative Easing & money supply management by central banks:

Quantitative Easing (QE) is a term very often in the news in recent times. Let us take a look at the what, why, how and when of it:

What it is:

It is a monetary policy that is used by governments to increase money supply. It is an unconventional system and is usually used only when the conventional methods of increasing money supply have become ineffective. It was first used by the Bank of Japan in early 2000’s to fight domestic deflation. More recently, it has been employed by the USA, UK and the Eurozone during the financial crisis of 2007-2010.

Why and when it is done:

Central Banks attempt to increase money supply in poor economic conditions when spending is low. There are various methods to accomplish the same, one of which is quantitative easing. Quantitative easing is sometimes viewed as a last resort measure when the more accepted methods of increasing money supply have become ineffective. It is generally employed when the interest rates are near 0% and have failed to produce the desired effect.

How it happens:

It is implemented by the central bank purchasing financial assets such as government securities or other securities from the banks and other public/private institutions with the newly generated money. This floods the targeted institutions with capital and hence increases the money supply. It is thus an attempt at driving up spending and hence consumption in situations when even a near 0% interest rate fails to elicit spending (the economy is in a liquidity trap).

Risks & Questions on effectiveness:

• More money enters the system without a corresponding rise in the amount of goods available. This will eventually lead to higher prices i.e., inflation. This nature of generating more money without more goods leads to quantitative easing sometimes being referred to as “printing money”.
• Increasing the money supply tends to depreciate the concerned currency’s exchange rates versus others. This directly harms creditors and holders of the currency as the real value of the currency decreases. Also, importers will be harmed as the cost of imported goods will be inflated by the depreciation of the currency. This could drive up prices of imported goods sharply.
• There is always the risk that the new money could be used by the banks to invest abroad and in asset classes like emerging markets, commodity-based economies, commodities themselves and non-local opportunities rather than to lend to local businesses.

QE could thus prove useless unless it is combined with effective policy measures in other areas.

Illustration by the Bank of England:

Further Reading:

• Quantitative Easing - an interactive graphic: http://www.ft.com/intl/cms/s/0/69e8c92c-e758-11df-880d-00144feab49a.html#axzz1c1MzJOIo
• Japan's sobering experience of quantitative easing: http://www.economist.com/node/14649284
• "Quantitative Easing" is simply a toxic phrase for a routine monetary policy - an opinion on Forbes:
  http://www.forbes.com/sites/beltway/2010/08/26/quantitative-easing-is-a-toxic-phrase-for-a-routine-policy/
• Nouriel Roubini a.k.a Dr.Doom's views on QE3: http://www.cnbc.com/id/44276918/QE3_Is_Coming_by_Year_End_Roubini