This article will explain the key concepts of Quantitative Easing. It will explain how Quantitative Easing works and the effects of Quantitative Easing on a country’s interest rates, inflation rates and exchange rates. This article will also go through real life examples of where Quantitative Easing has had to be used.
What is Quantitative Easing (QE)?
Quantitative easing is when the Central Bank purchases government bonds and assets from the financial market in order to pump money into the economy. Bonds are issued by the Central Bank/the government to increase the money supply, so they are able to finance and afford projects. This is thought to increase economic activity and business productivity. One way of doing this, is by simply printing out more money electronically. No cash is actually created. Quantitative Easing can also help bring a nation out of a recession in cases such as the Covid-19 pandemic and The Financial Crash of 2008.
The main aims and objectives of Quantitative Easing are as follows:
- To stimulate economic growth
- To increase economic activity
- To encourage banks to lend more money
- To promote consumer borrowing
- To increase investment
- To increase consumer spending
All of these things help a country to improve the rate of economic growth.
How does Quantitative Easing Work?
Firstly, the Central Bank purchases bonds from businesses in the private sector. They are purchased as government bonds and are bought in large quantities. The prices of these assets increase which means the yield on those assets decrease. The sellers of these assets use the money they received from the bank to invest in riskier assets and investments such as company shares and the stock market.
A reduce in yields reduces the cost of borrowing for individuals and businesses. This will lead to an increase in spending and investment. As banks have more money, they can finance loans which will encourage them to lend money to individuals. Since businesses have sold their assets to the Central Bank at a high price, they too can increase their spending and investment.
How does Quantitative Easing affect inflation?
Quantitative Easing is used when the inflation rate is negative or very low. Quantitative Easing helps ensure inflation doesn’t fall below the Central Bank’s target. With banks being reluctant to lend money, the rate of inflation could potentially rise. This could then promote borrowing (which is one of the aims of QE) as borrowers would pay lenders back with money worth less than what was originally borrowed.
The money that the Central Bank pumps into the economy increases spending which will help the inflation rate stay on track to meet the government’s target.
To summarise, Quantitative Easing will increase the rate of inflation as there is an increase in money supply. This will then increase interest rates which means banks are more likely to lend out money.
How does Quantitative Easing affect interest rates?
The government firstly purchases bonds in large quantities which will lead to a reduction of interest rates on those bonds. This will then decrease the interest rates on loans from the Central Bank. The retail banks would also decrease their interest rates to compete with each other.
When implementing Quantitative Easing, the Central Bank, more often than not, aims to reduce interest rates. For example, during The Financial Crisis of 2008, the Bank of England reduced interest rates from 5% to 0.5%. The main aim from this was to promote borrowing from banks so the consumer would then be able to increase their spending which in turn would stimulate economic activity.
How does Quantitative Easing affect exchange rates?
Quantitative Easing has a negative effect on a country’s exchange rate. Quantitative Easing can weaken a nations currency. This means Quantitative Easing depreciates a country’s exchange rates. Demand for the currency will decrease which will lead to a weak currency.
A depreciation in a currency will make exports for that country cheaper – meaning the country is selling their goods at a lower price which means lower profits. It will also make imports dearer. This is one of the drawbacks of Quantitative Easing. A country needs an appreciation in their exchange rates to make imports cheaper and exports dearer – where they can sell goods at a high price.
In which case could Quantitative Easing be ineffective?
One example of when Quantitative Easing may not work as effectively as planned is when consumer confidence is low. Consumer confidence is essential to making Quantitative Easing work effectively. Low consumer confidence would mean that the increase in money supply would have limited effect. If confidence is low, then consumers won’t take loans and thus they would not be able to spend money and purchase goods which would reduce economic growth.
An example of this is during the Covid-19 pandemic. In the UK, despite huge Quantitative Easing stimulus packages being announced, inflation remained low at 0.5% due to low consumer confidence hence it could be argued that the money supply would not have had its intended effects.
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