What is Quantitative Easing?
As the economy continues to struggle, both in the United States and around the world, we continue to hear talk about “quantitative easing” in the news. However, most people do not understand what exactly quantitative easing is or how it’s supposed to help the economy. Let’s take a closer look at how it works.
Quantitative easing (QE) is a last resort monetary policy used by central banks (i.e. the Federal Reserve) to stimulate the economy
In many cases, central banks can stimulate the economy by simply lowering interest rates by purchasing government bonds from the market. This encourages businesses and individuals to spend more money since the overall cost of borrowing money is lower. Makes sense, right? But what happens when interest rates are already close to zero and the economy is still struggling? The central banks are forced to find a new trick. This is when they turn to quantitative easing.
So what does quantitative easing mean?
Quantitative easing is implemented when the central banks print money and then use that money to buy assets from banks and other institutions. Basically, they are injecting a specified quantity of cash into the economy to increase the money supply. The idea is that banks will have more money available to lend to their customers who will spend the money and stimulate the economy. Increased spending results in an increased demand for goods and services which fosters job creation and economic vitality.
What are the potential problems with quantitative easing?
First, there is the possibility the banks may decide to hold onto the cash instead of lending it out to customers. Why would they do such a thing? Well, in a bad economy, they may not have had a lot of extra cash to begin with, and may want to hang onto it to reduce the risk that they will be unable to pay their own debts and go bankrupt. Another possibility is that the banks will not lend out the money if they simply feel that most of the potential customers are not credit worthy. No one likes to lend out money if they aren’t very certain they are going to get it back.
Another potential problem with quantitative easing is that banks are willing to lend money but customers are not interested in borrowing it. In a poor economy, people may feel they have too much debt already or be worried enough about their job security or the housing market that they do not feel comfortable taking on any more.
Clearly, if either banks decide not to lend or customers decide not to borrow, quantitative easing will fail to stimulate the economy as intended.
Another potential problem is that quantitative easing will actually spur too much spending in relation to the quantity of goods available, resulting in much higher inflation than desired, or potentially hyperinflation.
These potential issues are part of the reason why the decision by the central bank to implement quantitative easing can be difficult and controversial. As a result of the issues described above, past attempts to use quantitative easing to help the economy have not always been effective.