Monetary policies have been used for centuries to stabilize a country’s economy and inspire more public trust in the value of a currency. They’re used to ensure price stability and capital growth, improve employment rates and resource allocation, encourage investment, and accelerate economic development.
Central banks turn to several types of monetary policy instruments when the economy is taking unexpected turns, and among the most unconventional ones is economics quantitative easing (QE).
A complex yet powerful instrument, quantitative easing aims to reduce interest rates and increase the money supply. Learn all there is to know about it below.
The fundamentals of quantitative easing
Monetary policies can be categorized into two types:
- Contractionary policies;
- Expansionary policies.
Contractionary policies slow down the money supply to the economy by keeping interest rates higher and discouraging borrowing and investing. Expansionary policies are the exact opposite, increasing the supply of money and decreasing interest rates. Quantitative easing belongs to the latter category.
While different monetary policies have been used for decades, the history of quantitative easing and investing is rather short. It was first implemented in the US in 2008 as a response to the Great Recession. It was then used in 2010, 2012, and most recently in 2020.
When implementing QE, the central bank (Federal Reserve in the US) makes heavy investments into long-term securities, stocks, government and corporate bonds, and other financial assets. Doing so automatically increases the money supply in the economy, thus lowering interest rates, encouraging borrowing, and inspiring healthier economic activity.
In situations like the Great Recession, when the target interest rates, also known as Federal Funds Rates, are already low and cannot be reduced any further, the Fed deploys economics quantitative easing to prevent the economy from freezing and encourage the public to keep spending.
The inner workings of economics quantitative easing
Economics quantitative easing is a complex monetary policy tool, but we can summarize it in a few simple steps:
- The Federal Reserve gives its member banks cash in exchange for financial assets (bonds, stocks, etc.);
- The member banks receive cash, which they can use to purchase other assets or to lend out to the public;
- The new money that’s entered the economy increases the availability of loans and makes the loan approval criteria less stringent;
- The prices of financial assets go higher when the Fed makes hefty purchases, but the yields go lower, making it cheaper to borrow;
- Lower yields push the investors to change their asset allocation and invest in higher-yield options such as stocks and shares.
Ultimately, individuals and businesses develop growing confidence in the economy, making them more likely to spend, invest, and borrow.
Of course, the Fed can also discourage spending through quantitative tightening if the economy is expanding too quickly – a policy that is practically the exact opposite of QE.
Benefits of quantitative easing
Although it’s certainly an unconventional monetary policy, QE has numerous advantages for the public, banks, and businesses. It’s a quick solution that boosts economic activity during uncertain times, such as the 2020 pandemic.
First and foremost, QE encourages spending. The whole purpose of this instrument is to make borrowing and lending easier and more affordable.
With lower interest rates, individuals and businesses feel less uncertainty about borrowing. They then use the borrowed money to make purchases, hire more employees, expand their businesses, etc.
Ultimately, QE stimulates the economy and improves the circulation of money.
Increases asset prices
As mentioned, increasing the price of assets encourages investors and traders to change their asset allocation techniques. The Fed replaces financial assets with cash that you can then use to invest in other financial markets.
Furthermore, the Fed can use QE to remove the unsellable toxic assets (such as subprime mortgages, for example) from circulation. Once the economy has stabilized, the Fed can then slowly release these assets back into circulation without causing damage.
Keeps unemployment rates stable
In times of economic uncertainty, employment rates are known to drop – think of the low employment rates during the Great Recession or when the 2020 pandemic started. With quantitative easing, employment rates can remain relatively stable.
With more money circulating in the economy, businesses can afford to keep their employees and hire new ones with ease. They can expand their operations and prevent unemployment rates from reaching their all-time highs.
Risks associated with quantitative easing
No monetary policy is without its drawbacks. Here are some of the biggest risks associated with quantitative easing:
- Quantitative easing could lead to inflation and stagflation;
- It could create asset bubbles (the price of an asset rises without the underlying fundamentals);
- It could lead to income inequality;
- It could devalue the national currency.
Quantitative easing is an emergency measure designed to quickly solve economic problems, so it’s not surprising that it could negatively impact the long-term stability of an economy. Still, when deployed properly, you can easily minimize its negative impacts.
Economics quantitative easing is a complex monetary policy that aims to inspire healthier economic activity. It offers a quick fix in a crisis, but you should always implement it carefully.