Quantitative Easing (QE)

Money cannon

Quantitative easing (QE) is an action taken by a central bank to stimulate the economy that it presides over.

The action that the central bank takes is to buy financial assets. These assets are usually in the form of government, bank or business bonds.

In order to make these purchases, the central bank electronically creates more money – contrary to the associated term 'printing money', they do not actually print physical paper money.

What are the assets?

In order to understand how QE works, an understanding of what the actual assets are that are being purchased is essential.

Government and banks issue bonds to borrow money

When banks, businesses or governments want to raise money, they can sell an 'asset', usually in the form of a bond. You'll see that this is another way of simply borrowing money and the buyer of the bond is lending money.

When banks, businesses or governments want to raise money, they can sell an 'asset', usually in the form of a bond. When an institution sells a bond they pay the money back at a set date in the future and pay interest on it.

The buyer of the bond hands over money to the institution and the buyer receives the bond in return. The buyer will hold this bond for a set period of time, so in other words, the bond 'expires' on a set date in the future.

When the period of time is up, the institution pays the buyer back. Of course, the buyer would never purchase the bond if there wasn't a good reason to do so, and so the institution pays the buyer interest. So the bond buyer makes a profit.

Bonds are intangible – a contract agreement

A bond is not a physical thing, it's actually just a contract between two parties, but they can be sold and traded. As such, in a free market, they are subject to supply and demand, meaning that if there is not much demand for the bonds, then the institutions will lower the price of them and pay a higher interest rate to the buyers to entice them. If there is a lot of demand for these assets, then the price of the assets will go up and the interest rate that the buyer receives will go down.

The 'assets' that central banks purchase with newly electronically created money are usually the bonds of governments, banks or private firms.

Whatever the interest rate is, the seller of the bond has raised money to invest into other things and will make a return on those investments. But the higher the interest rate, the more money has to be paid out and the less money is left over after the seller has invested the money.

So when a Central bank states that they will purchase assets, they are effectively buying these bonds. To illustrate further, if a central bank states that they are about to undergo $50bn of quantitative easing, they are buying $50bn worth of financial assets or bonds. The seller of the bond can then use that money to invest into other things.

Quantitative easing is designed to stimulate the economy

Interest rate

Usually, the most powerful tool that the central bank uses to stimulate the economy is the lowering of the base interest rate it charges national banks. However, when the interest rate is already the lowest it can go, the central bank has to resort to other means to stimulate the economy and QE is one of them.

Quantitative easing stimulates the economy in the following way:

  1. New money is created and used to buy financial assets of institutions.
  2. These institutions get a fresh injection of cash that they can use to invest and spend.
  3. The extra money injected into all these firms in the economy increases the money supply overall.
  4. The price of financial assets go up under the new demand and the yields of the assets (the interest rate paid to the buyers) falls.
  5. Institutions start buying assets of other institutions, further increasing the price and lowering the yields paid out.
  6. With less money being paid out in interest, these institutions now have more money to spend, lend and invest.

Lower yields on assets lowers the interest rates for borrowing money overall

When central banks buy substantial quantities of assets, they force the price of them up and the amount of interest that needs to be paid (the yields) down. This means the sellers of bonds have more money to spend and invest.

When the yields of these bonds in the economy fall, this has a very clear benefit for everyone else, because it lowers the cost of borrowing for everyone else.

This is because, now that the institutions do not have to pay as much to the buyers of their assets in yields, they now have extra cash on hand. With the extra money that these institutions now have, they can invest into new things, hire more staff and expand. They generally buy other assets with the money they get to invest and grow.

Those companies that lend money, such as a bank or other financial institution, have more on hand to lend and can therefore afford to lend more and at a cheaper interest rate.

If you think about a single loan, where a bank lends money to a customer for a certain amount of interest (fixed or otherwise), this is essentially a so called 'financial product' that the borrower purchases from the bank. What the central bank has effectively done with QE, is allowed the supply of financial products on the market to increase as a whole (across all of the banks) – when the supply of something increases, then the price of it falls.

Supply and demand

Of course the banks don't have to lend at a lower rate, they can lend at any rate they want to (above the base rate of the central bank sets). However, banks make money on the loans that it issues out to borrowers and they want to make as many loans as possible. But of course, all the other banks are able to make more loans at a cheaper rate too and as the bank will want to entice as many people to take out loans with them, they will lower the interest rates to compete with other financial institutions.

In theory, this lowering of interest rates is probably the most direct benefit that consumers feel from quantitative easing.

Lower borrowing costs encourages spending and stimulates the economy

When the cost of borrowing money falls, consumers and businesses borrow more money and buy more goods. The following – very rudimentary – example explains how this works:

If the cost of borrowing falls, people naturally borrow more and spending in the economy increases.

Say, for instance, the more vans you have for your delivery business the more you can expand. You consider a $20,000 loan to buy a van and the payments are $250 per month. If the cost of borrowing falls by half, then you can now be take out a loan for £40,000 to buy two vans for the same cost of $250 per month and so you are likely to buy two vans and expand your business even more.

More spending leads to inflation

As this effect starts to take place and spending and investment picks up across the whole economy, prices overall start to increase leading to inflation. This is either a good thing or a bad thing, depending on how high the inflation is.

Central banks will engage in QE if there is a danger of deflation. Deflation is bad for the economy because it encourages people and businesses to not spend and invest.

It is generally accepted that a small amount of inflation is a good thing for the economy, because it encourages spending and investment. If prices are rising, then investors are likely to buy or invest in assets because they believe they will get a return for it in the future. If prices do not rise, or even fall (deflation), then investors are more likely to hold onto their money, because they do not want to invest in something that is going to be worth less over time.

So, a direct result of quantitative easing is inflation and a central bank will engage in quantitative easing if it believes that there is a danger of deflation.

So you can see that quantitative easing has the same effect of lowering the interest rate, but can be used when the interest rate can go no lower.

The debate around QE

Quantitative easing and its benefits are heavily debated in terms of the actual effects and the extent of them, and so it is worth bearing in mind that the text book theory of how QE works remains under scrutiny.

For instance, it has been widely reported in the 2008 crises that QE did not in fact end up stimulating investment, but rather allowed big banks that lost money on heavy speculation in the sub-prime mortgage industry to re-capitalise their own balance sheets. So far from encouraging lending in the economy, banks sucked up the readily available capital to affirm their own footing in a financial crisis.

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