What is quantitative easing?
It is an extraordinary monetary policy that involves the purchase of securities by the central bank from the market in the hope of stimulating economic activities. It is usually introduced when there is a crisis and as an alternative policy when the interest rate is very low or negative and cannot be used to help economic recovery. This situation is known as a liquidity trap.
By buying securities (private and public), the central bank increases the money available to financial institutions that can be given out as loans to individuals and businesses. The lower interest rate will encourage more borrowing for consumption and investment, thereby boosting aggregate demand and economic growth.
It was used by Japan in the early 2000s to save its economy after maintaining an interest rate close to 0% to solve the problem of deflation. Many other countries used it during the global financial crisis of 2008.
The US Federal Reserve purchased a lot of securities in the aftermath of the Financial Crisis of 2008. It was meant to help the economy recover from the recession triggered by the financial crisis by lowering interest rates, improving confidence, and helping the economy recover. It increased borrowing and spending.
Importance of Quantitative Easing (QE)
Economic recovery in a period of crisis
QE is useful in restoring or stimulating economic activities when there is stagnation or a crisis. It is capable of encouraging borrowing, consumption, and investment when conventional Monetary Policy, such as interest rate, may not be effective
Tackling deflation
Falling prices are harmful to the economy if caused by declining aggregate demand. QE increases the money supply, which bolsters total demand for the economy’s goods and services. Deflation will be controlled if aggregate demand is rising.
Reduces the interest rate
The purchase of securities, such as bonds, by the central bank from the market increases the demand and prices of securities. Rising securities prices cause interest rates to fall. This can, in turn, encourage borrowing by individials and businesses for consumption and investment.
Improving Financial Market Liquidity
QE provides banks with additional reserves, helping stabilise the financial system, especially during a crisis.
Boosts confidence
Rising asset prices boost the purchasing power of the holders. They are more confident to spend because they are getting richer.
Rising Expectation
The use of QE to bail the economy out of crisis sends a signal to economic agents that the central bank is dedicated to supporting the economy. Rising expectation encourages spending by both households and businesses. It can stimulate economic activities and create jobs.
Criticisms of Quantitative Easing
Limited impact if banks are unwilling to lend and businesses are unwilling to borrow
QE may not have the desired effect if banks are unwilling to lend. When the central bank pays for the securities it buys, reserves of commercial banks rise. Consequently, more money is available to lend to the public. However, the absence of creditworthy borrowers may discourage the banks from lending. Also, businesses may be reluctant to borrow if there are no profitable opportunities or if business confidence is low.
Inflationary pressure
QE can fuel inflation due to increased borrowing and spending. It is worse if the central bank uses it too often because there will be excess liquidity. A lot of people can easily obtain loans from banks to spend, thereby increasing AD.
Weakens the domestic currency
A falling interest rate caused by QE reduces the demand for the currency due to decreased hot money flow. This causes depreciation of the currency. Depreciation gives a country an undue advantage in the international market because its exports are cheaper. This can cause retaliation by other countries.
Ineffective in the long run
The long-term success of QE depends on how well it is combined with fiscal policies to reduce its negative effects, such as inflation, rising asset pricing and inequality.