QE – Quantitative Easing

26 Jun QE – Quantitative Easing

[Note from the author: This post was originally published in 2012 on a blog entitled “Further to Freedom.” This blog was an attempt of mine to communicate some of the complexities of economics in an accessible, easy-to-understand way. The blog was organized by ‘Levels’, which I thought would help readers to select articles which better corresponded to their level of economic understanding. I had originally envisioned this as a collaborative project and wanted to bring in a handful of others to contribute articles. That vision never materialized, but the time I committed writing and working on the project gave me a deeper understanding of the topics, and I’m still happy to share the work. This particular article was categorized ‘Level 4’.]

In order to understand quantitative easting, or QE, it is important to first understand the role of the central banking system (Federal Reserve Bank, in the US) in the economy at large.  Central banks are the highest monetary institutions in a country. They have the role and responsibility of protecting the economy and promoting economic growth, and they accomplished this by utilizing various tools.  Based on the  executive privilege and authority they receive from the federal government, central banks can adjust government interest rates, lend last-minute money, and print additional money in order to adjust the economy.  Since its creation in 1913, the Federal Reserve Bank has utilized many of these tools to regulate the economy and promote growth.  These strategies have experienced both positive and negative results.

One of the tools the Federal Reserve has at its disposal is quantitative easing.  Many economists, particularly in the Keynesian school, believe that injecting more money into the economy will promote growth and help to create jobs.  The theory is that when there is more money in the hands of businesses they will have more ability to grow, to extend the business, and to hire new employees.  Many of the tools in the Federal Reserve’s toolbox are aimed toward putting more money into the economy.  When the economy is lagging the Federal Reserve may lend out money to large banks, giving those banks more money to lend to businesses and other institutions, gradually trickling down to the benefit of each citizen.  Or, if banks are unwilling to lend money because of a poor economy, the Federal Reserve may reduce the Federal funds rate, making it more appealing to lend money.  These tools have limits, however, and once the Federal funds rate is lowered to near 0%, it naturally can no longer be reduced.

If the Federal Reserve wants to inject money into the economy but cannot do so by normal means (like those listed above), it can buy financial assets from large institutions, thereby putting cash into those institution’s hands–this is quantitative easing.  The theory is that this new money in the institution’s account will stimulate institutional growth and trickle down to the rest of the economy. Here is where it gets tricky, though–to purchase assets one must first have capital, right?  One needs cash before he or she can shop at the grocery store. So to foot the bill, the Federal Reserve simply adds zero’s to those institution’s bank accounts.  Simple, right?  It’s an easy way of ‘printing’ money, and it’s cheaper, too!

The natural effect of printing new money is inflation, and this is exactly what the Federal Reserve believes will assist the economy.  There are, however, some negative side-affects that can result from QE, otherwise it would be used more often (as yet the FED has only used QE twice.)  The biggest risk is that the economy could experience even higher inflation than the QE expected.  This is partly why QE is used less often.  Nonetheless, the Federal Reserve considers the economy as a whole and attempts to reign in inflation to their ‘target rate‘ as much as possible.

Check back for articles about the use of QE and other Federal Reserve tools in the past.

The video below does a wonderful job visually illustrating Quantitative Easing.  Give it a watch!

[youtube http://www.youtube.com/watch?v=Lmd_CDwBXFs]