What is Quantitative Easing?

Quantitative Easing (QE)

First Published Date : November 17, 2010 ADawnJournal.com

When someone hears the words “quantitative easing”, they can be forgiven for not knowing exactly what that this financial concept is. After all, it is a complex concept that many people, people outside the financial industry, simply do not understand.

Quantitative easing is a monetary policy that is used by central banks as a way to increase the overall supply of money, which allows them to increase the reserves of the banking system. This is typically done through the purchasing of central government bonds, in order to stabilize, and/or prices and thereby lower long-term interest rates. When normal methods at controlling the money supply have failed, this method is typically used.

As for how the policy is implemented, quantitative easing is done in the following method:

1.   A central bank will credit its own account with money it creates.

2.   The central bank then purchases financial assets which can include agency debt, mortgage-backed securities, corporate bonds and government bonds. This gives the bank an excess of reserves that allows them to create new money, thereby creating economic stimulation.

Obviously, there are risks associated with quantitative easing. Sometimes the policy is not effective enough if banks don’t use the additional money they have made in order to increase capital reserves, which then increases the risk of the bank defaulting on its loan portfolio, which can cause many more problems down the road. Another problem is that quantitative easing can create an excess of inflation, more than is desired, and even lead to hyperinflation.

The Bank of Japan used quantitative easing in order to fight against the deflation of the domestic currency in Japan. Recently, thanks to the massive economic crisis that has gripped the world, the United States Federal Reserve has used quantitative easing to fight the effects of the recession. The European Central Bank has also used 12-month long-term refinancing operations through the process of expanding on assets that the banks can then use as collateral.

The reason that it failed with Japan is because the Bank of Japan maintained short-term interest rates at close to zero values for several years. Then, using quantitative easing, they flooded banks with an excess of money in order to influence private lending. This then caused large stocks of excess money, which then create a small risk of money shortfalls.

Japan actually created quantitative easing, with the Bank of Japan adopting the policy on March 19, 2001. However, the earliest written record of the term dates back to Richard Werner, a professor of international banking at the School of Management in the University of Southampton, when he warned of the coming collapse of the Japanese economic banking system.

So, that essentially sums up quantitative easing and what it is. While it may still be difficult to understand, you at least have a basic understanding of what this unique financial tool is and the effect that it can have on your life. During this financial crisis, it is clear that quantitative easing may be the one way out of it for many central banks.