What is Quantitative Easing? A Guide to This Monetary Policy Tool

In most countries, the government and its policies drastically affect the share market. This is because government figures, their views, and policies shape society and set the tone for the economic year. Each government has an agenda that it tries to fulfil, but among the agenda, almost always, a vital promise is increased, and economic growth is pushed forward. This may result in changes in tax cuts, the job market, industrial businesses, and much more. All major publicly traded companies may be affected to some extent when a government enforces new laws and mandates. 

The market may be slow for various reasons, such as financial instability and the economic downturn. Buyers and sellers may fear losses on both sides and avoid the market altogether, a big problem for a country’s economy and federal reserves. If there is a decreased cash flow in the country, the government tries to help the economy grow and become stable—one way of doing this is quantitative easing or QE. 

Quantitative easing is a monetary policy tool that central banks worldwide use to increase cash flow and ease the effects of an economic downturn. This tool has been seen to work very well in many past scenarios. It is also credited for bringing economic stability to the United States of America after the 2008 financial crisis. Governments turn to this tool when all other ways of ensuring economic stability, like lowering interest rates for the short term, fail. 

This monetary tool is relevant in today’s economic climate. Since the end of the COVID-19 pandemic, the world has been trying to regain its stability. Still, there is economic turmoil; almost every aspect of the global trading world is struggling one way or another; the companies that were booming before the pandemic are finding it hard to stay afloat, and some have already given up. Simply put, the economic world has taken a big, irreversible hit. In such conditions, where generally used tactics have fallen short, quantitative easing seems to be the attractive direction to pursue. 

The primary purpose of quantitative easing is to bring activity to the economic world, which will increase the cash flow, possibly avert an impending recession, and, overall, get a sense of stability to the economy. Although quantitative easing is brought about through government policies, these policies may be monetary or fiscal, depending on the scenario. There is a lot of information regarding quantitative easing and how it is conducted, so in this article, we will cover everything you need to know about it, including how it works, its impact on the economy, and more. 

Understanding Quantitative Easing

There are different types of government policies, one of which is a monetary policy. A monetary policy involves the central bank of the country and mandates policies that use interest rates, taxes, and related instruments to shape the country’s economy and bring stability. One such instrument is QE, where the government, through the central bank, buys different financial assets from commercial banks and financial institutions to increase and stabilise money flow, encourage buyers and sellers to participate in the market, decrease interest rates, and increase lending and investment opportunities. 

When a country’s economy faces hardship, the central bank decreases interest rates temporarily to control inflation and boost economic growth. However, there is a limit to how much the interest rates can be reduced. This is where quantitative easing comes in. It is a last resort for the government and helps bring cash flow directly into the system. 

The government buys financial assets like government bonds, corporate bonds, and securities from commercial banks. This increases the banks’ financial reserves, meaning they have more monetary power to lend capital and lower interest rates. This entices the general public to take out loans and fund their businesses. The road to economic growth and stability is non-linear, with roadblocks and occasional bumps. Many things have to go right for an economy to boost while using quantitative easing. The total effect of this easing on an economy can thus not be comprehended. 

How Quantitative Easing Works

As explained earlier, the road to economic growth and stability is non-linear and requires meticulous efforts from all the parties involved. To completely understand the workings of quantitative easing, we first need to understand the role of all the involved parties. These parties include:

The Government

In any country, the government is responsible for bringing opportunities to increase the cash flow. There are various ways the government can do that. Some of these methods include building and funding new and attractive projects, introducing policies that help and encourage people to invest or trade, and so on. The elected government thus has the most significant influence on the economy in terms of interest rates, stability of the markets, and its activity. 

The Central Bank 

Any country’s central bank is responsible for enforcing the government’s monetary policies and foreseeing and managing the country’s wealth and economic growth. It is one of the most important institutions of a nation, and its ultimate stability and strength depend on it. 

Commercial Banks and Financial Institutions 

Commercial banks and financial institutions are the backbone of any country’s economy. These institutions act as the financial intermediaries between the general public and the trading world; they ensure cash flow, allocate capital, and bring activity to the economy, which drives a country. 

The General Public

The general public might be the most critical piece of the puzzle. The above parties exist only to serve the general public and its best interest. The general public’s action ultimately drives economic activity. In days of economic downturn, if the public stops trading because of the fear of bearing losses, all the above parties would move to rectify the situation. 

Now that we understand the role of each part involved, let us look at how quantitative easing works. We understand that it is used when all other generally used tactics of stabilising the economy have failed. In an unstabilised economic situation, commercial banks and financial institutions lose much of their lending business because of high interest rates, where the general public cannot afford to take up loans. This depletes their reserves, meaning the economy has less cash flow. In such conditions, the government buys financial assets from commercial banks and financial institutions through the central bank, which the general public would otherwise buy. This creates direct monetary flow in the bank’s reserve, which helps it lower interest rates. 

With lower interest rates, the general public might be attracted to take loans from institutions and bring activity to the economy. This effort decreases inflation, increases cash flow and bank reserves, and stabilises a country’s economy.

The Impact of Quantitative Easing

QE is a potent monetary policy tool that can profoundly affect a country’s economy. Governments help ease inflation and economic instability by buying financial assets from commercial banks. As many parties are involved in quantitative easing, its overall impact is widespread. 

Quantitative Easing and Interest Rates 

There is an inverse relationship between government bonds and interest rates. When government bond prices are low, the interest rates are high, and vice versa. Quantitative easing exploits this inverse relationship. The central bank buys the government bonds from a long list of financial assets the most. When the government buys these bonds, their prices increase, causing the interest rates to drop. With decreased interest rates on loans, mortgages, and more, the general public enters the market again.  

Quantitative Easing and Economic Activity

Once the general public enters the market again, economic activity is stimulated. This means that businesses lend money to expand and, in return, create more jobs and revenue, and the public spends on housing, consumer goods, and services, adding more to the economy. Consumer spending is one of the biggest drivers of economic growth; as quantitative easing increases this spending, it indicates success. 

Quantitative Easing and Financial Institutions 

Financial institutions like banks, insurance companies, and funds welcome quantitative easing. This monetary policy tool brings liquidity to the market, which drives these institutions. However, quantitative easing might become problematic for banks and insurance companies after a certain point. This is because, for these institutions to stay afloat and make a profit, they need to keep the interest rates at a certain level. 

Short and Long-Term Effects of Quantitative Easing 

It can be concluded that the short-term effects of quantitative easing include:

• Lower Interest Rates
• Stimulated Economic Activity and Potential Growth 
• Increased Liquidity in the Market 

The long-term effects of quantitative easing include:

• Unsustainable Consumer Debt 
• High-Dependence on Quantitative Easing
• Risk of Inflation 
• Devalued Currency

Historical Context and Case Studies

The 2008 financial crisis, commonly known as the Great Recession, is one of the world’s most significant economic collapses. It started in the United States of America and spread worldwide, causing some of the biggest names in the banking sector to fall to the ground. Around the end of 2008, central banks worldwide started buying government bonds from commercial banks and institutions, starting a wave of activity in the market. This is where quantitative easing was coined and seen for the first time. 

Since then, many countries and their respective central banks have successfully used this technique to bring economic stability. These central banks include the Bank of England, the European Central Bank, and the Bank of Japan. Among all these big names, Japan has been the most aggressive user of quantitative easing, and the Bank of Japan has bought everything from government bonds to real estate to ETFs. However, a real eye-opener is that Japan still struggles with its economic stability even after a decade-long quantitative easing. 

Risks and Criticisms of Quantitative Easing

Quantitative easing is used to provide relief to the economy and the general public. However, prolonged or consistent use of this tool poses risks and comes with criticism. Here, we list the significant risks and criticism associated with quantitative easing:

Risk of Inflation 

The risk of inflation is the biggest drawback of quantitative easing. Consumer action increases when the government buys through the central bank and brings liquidity to the market. With time, this increase will affect the prices of consumer goods if the economic growth does not keep up with the new cash flow. This will bring the situation back to square one: economic instability. 

Increased Consumer Debt 

Since the market is liquid and interest rates are decreasing, consumers boost spending and lending, which increases the chances of unsustainable consumer debt. This would again mean economic instability and tension in the trading world. 

Dependence on Quantitative Easing 

If quantitative easing is applied occasionally, a country’s economy may depend on it drastically. This would mean that every time there is a downturn in the market, the stability will be brought back only by pumping money into reserves for a short period of time. 

Printing Money Theory

One of the biggest criticisms of quantitative easing is that experts believe that the government buying assets and giving money to commercial banks and financial institutes is basically like printing money whenever there is a shortage. This money does not represent the country’s actual economic activity. 

Quantitative Easing vs. Quantitative Tightening

Quantitative easing and tightening are two opposite monetary policy tools. In QE, the government buys assets from commercial banks to bring activity into the market; however, in quantitative tightening, the government sells these assets to lower inflation by removing liquidity from the markets. Both techniques are used to bring economic stability to the country ultimately. Here we look at some of the similarities and differences between quantitative easing and tightening:

Quantitative easing is a monetary policy tool used to bring economic stability to a country. Many different parties are involved in the successful execution of quantitative easing. The term was first coined at the end of the 2008 financial crisis, after which many countries and central banks used this tool to bring economic activity to the market. 

Through quantitative easing, the government buys financial assets like government bonds, corporate bonds, and securities from commercial banks and financial institutions. This increases the banks’ financial reserves, meaning they have more monetary power to lend capital and lower interest rates. This entices the general public to take out loans and fund their businesses, causing economic activity needed for stability. If this tool is used for a long time, it may negatively affect the economy and sway it from stable to unstable conditions. Still, this tool is one of this century’s most genius monetary policies.