BAJAJ BROKING
November 19, 2024
6 mins read
In this article, we will discuss quantitative easing and how it works. We will talk about the risks associated with it and some real world examples. We will also touch upon the pros and cons of the policy.
Quantitative Easing or QE is an unconventional monetary policy instrument undertaken by central banks with an aim to stimulate the economy during recessionary phases or low inflationary cycles. Central banks buy financial instruments, such as government bonds, to increase money supplies, reduce interest rates, and stimulate lending and investing. It is typically resorted to when the cut in interest rate fails to work more effectively. Although not directly relevant to traders and investors, anyone with a trading account should ideally have some understanding of what quantitative easing is. Let’s explore it further.
Quantitative Easing is designed to inject liquidity into the financial system by increasing the reserves of commercial banks. Central banks purchase long-term securities, such as government bonds or mortgage-backed securities, from the open market. The increase in liquidity allows banks to lend more freely, which lowers interest rates and boosts economic activity. The idea is to make borrowing cheaper for businesses and individuals, encouraging spending and investment. While QE can provide a short-term boost to the economy, it must be carefully managed to avoid long-term risks such as inflation or asset bubbles. Now that we know the quantitative easing meaning, let’s move on to how quantitative easing works.
Additional Read: What is Demat Account: Importance, Features and Types
Quantitative easing is used when monetary policy tools traditionally practiced by the central banks, such as lowering the short-term interest rate, do not fulfill their aim of stimulating the economy. In QE, money is electronically created to buy government bonds and other financial assets. Such purchases increase the reserve balances of banks to lend more, thereby lowering long-term interest rates. A decrease in the rate of interest lowers the cost for borrowing. Business and consumers can spend and invest with more ease. Besides that, it could increase the price of financial assets such as equities and bonds, hence increasing investor optimism and encouraging additional economic activity. Now that we understand how quantitative easing works, let’s focus on some of the risks associated with it.
Inflation
One of the principal risks of quantitative easing is that it creates inflation. Increasing the money can prove to be counter-productive for the central banks as prices are not going to be reined in if the supply doesn't match up with the demand of goods and services. Overuse of QE may again boost rates of inflation, thereby decreasing the purchasing power and destabilizing the economy.
Limited Lending
Although the policy implemented in QE increases the level of liquidity, it does not insure lending during uncertain economic times. In other words, if the banks keep the additional reserves instead of lending, then the expected benefit to the economy is limited. This can weaken the impact of QE.
Devalued Currency
This can lead to devaluation of the national currency. The money supply rises because the central bank lowers the value of the currency with others. Although a low-valued currency makes the country's exports cheaper, it increases the cost of imports, thereby driving the domestic economy's price level upward.
A number of important economies engage in quantitative easing during economic meltdown. The Federal Reserve in the United States has implemented QE since the 2008 global financial crisis. The Fed purchased trillions of dollars worth of bonds to stimulate the economy and push down long-term interest rates. Similarly, the European Central Bank launched QE in 2015 as part of the fight for low inflation as well as a means to stimulate economic growth in the eurozone. Japan had turned to QE since the early 2000s as a way of pulling its economy out of deflation. The above examples tend to reveal that QE is one of the useful weapons of a central bank in its fight against economic slowdown.
Quantitative easing is resorted to by the central banks when they seek to stimulate the economy but the conventional tools such as reduction of interest rates are no longer functional. When central banks buy long-term financial assets, it injects money into the monetary system, increases liquidity, and reduces long-term interest rates, thus encouraging banks to lend more which is followed by business and consumer spending. More importantly, the effect of QE can create an increase in asset prices, enhancing wealth and boosting investor confidence. Generally, QE is also stockpiled for an economic situation which might be as drastic as a recession or even a deflationary scenario. At such times, even more aggressive measures would be needed in order to stabilize the economy.
While there are some inherent benefits of quantitative easing as a policy it comes with its own disadvantages.
Pros | Cons |
Reduces long-term interest rates making borrowing cheaper | Injects excess money in the economy may lead to inflation |
Promotes investment and spending | May bring low lending if lending banks are not interested in lending |
It drives up asset prices, thus boosting investor confidence. | It can also reduce the national currency because with every dollar issued, the price of imports rises. |
Financial markets are now liquidated so that financial crisis is cushioned. | There is now a possibility of asset bubble building in equity or real estate markets . |
This shields the central bank from the vicious spiral of deflation | It tapers off if it is frequently or for an extended use returns. |
Here are some of the important drawbacks of quantitative easing.
Inflation Risk: Injection of huge money into the economy evokes inflation if there exists a dearth of goods and services that can meet demand. Higher inflation lowers the money value of purchases in it and threatens to destabilize the economy.
Asset Bubbles: QE brings about higher asset prices, including stocks or real estate. Over-valuation of some of these assets leads to asset bubbles which can be very hazardous should they burst. This leads to economic instability.
Worsened Income Inequality: Worsening Income Inequality: QE tends to favor the better-off since their assets get increased when the prices for these assets appreciate while doing little directly for the less privileged.
Currency Devaluation: By enlarging the money supply, QE tends to reduce the value of the national currency to make imports expensive and enhance inflationary pressure.
Diminished Long-Term Effectiveness: As the longer QE is utilized, its effectiveness can deteriorate as the markets become accustomed to its impact and unproductive effects are reached in encouraging growth.
Quantitative easing is a monetary policy tool of significant power as it enables central banks to trigger growth during financial crisis periods. Generally, quantitative easing encourages spending, investments, and development in an economy as long as the money supply increases and long-term interest rates decrease. However, its application should be done with some care due to the risks associated with inflation, devaluation of currency, and potential asset bubbles.
While quantitative easing may work well during a recession, policymakers should be very cautious regarding its risks and long-term impact. Properly implemented QE promotes economic growth, reduces unemployment, and prevents deflation. However, it can only be a short-term solution and should have a well-calibrated exit strategy to avoid being misinterpreted as inflation or distortion in the markets.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Quantitative easing (QE) is a monetary policy where central banks purchase financial assets, such as government bonds, to increase the money supply and lower long-term interest rates. This encourages lending, spending, and investment, helping to boost economic activity during recessions or periods of low inflation.
The main goals of quantitative easing are to stimulate economic growth, reduce unemployment, and prevent deflation. By increasing the money supply and lowering interest rates, QE encourages borrowing, spending, and investment, which boosts overall economic activity.
Quantitative easing lowers long-term interest rates, making borrowing cheaper. It can also lead to higher inflation if too much money is injected into the economy without a corresponding increase in the supply of goods and services. This is because the increased money supply can drive up demand, leading to higher prices.
The potential risks of QE include inflation, the creation of asset bubbles in financial markets, a devalued national currency, and increased income inequality. There is also a risk that banks may not lend the additional reserves, limiting the effectiveness of QE in boosting the economy.
Quantitative easing was used extensively during the 2008 global financial crisis and the COVID-19 pandemic by central banks, including the U.S. Federal Reserve, European Central Bank, and Bank of Japan. These institutions purchased large amounts of government bonds and other financial assets to inject liquidity into their economies, lower interest rates, and encourage lending.
Alternatives to quantitative easing include traditional monetary policies like lowering short-term interest rates and fiscal policies such as government spending and tax cuts. Other tools include direct interventions, such as providing loans to banks or specific industries, or targeted stimulus measures to support consumer demand and business investment.
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