Quantitative Easing

by Stephan Smith on November 9, 2010

If you’re wondering what quantitative easing is, then you’ve made it to the right place because I am going to explain to you exactly what it is, how it affects an economy, who is responsible for performing it, what is reason for performing it, and what it means for an average person.

What is Quantitative Easing?

Quantitative easing is the act of creating money and adding that created money to an economy’s money supply by purchasing assets for the purpose of stimulating that economy. Quantitative easing also goes by the term of ‘Asset Purchasing Program’. The entity responsible for performing quantitative easing is a country’s central bank.

When Quantitative Easing Should be Considered

All central banks have major roles in their respective economies. The two most common roles shared amongst central banks is to ensure economic growth and to ensure price stability or currency value. But when trouble shows its ugly head and a central bank’s economy starts to falter, a central bank will have to take action to make sure that it fulfills its duty.

Usually when an economy starts to show signs of contraction, a central bank will take steps to make its monetary policy more accommodating for economic growth in an effort to combat its economy’s economic woes by lowering its overnight interest rates. If that doesn’t work, and it takes a really bad economic situation for that to be the case, then a central bank may start to look for other possible solutions. One being quantitative easing. Quantitative easing should be consider by a central bank if primary efforts fail to stimulate a faltering economy.

How the Money is Created to be used for Quantitative Easing

Remember, quantitative easing is the act of creating money and adding that created money to an economy’s money supply. But one thing may have caught your attention is ‘the act of creating money’. You may find yourself asking, just how is money created to be used for quantitative easing? That’s a good question. Central banks have the power to create and issue money.

When I say ‘create’, I mean they just make it. It comes into existence simply because they say it now exists. The central bank would also make the new money tangible by entering some numbers into a computer or by printing it. Poof, you have new money. My explanation may be over simplified, but overall, that’s how it’s done.

How New Money is Added to an Economy

Once a central bank creates new money, it is now tasked with the duty of somehow adding that newly created money to its economy’s money supply. This is accomplished primarily through the purchasing of its country’s government bonds.

A central bank may also decide to purchase other securities or assets to help inject the newly created money throughout the economy. The decision on what to purchase is on the central bank and the central bank only. Usually, government bonds are the route central banks take. A central bank may also decided to use all of its newly created money in one massive purchase of government bonds or it may decide to purchase its country’s government bonds over time, little by little. It’s obvious that a large, one-time purchase would create more of a shock in an economy rather than a little by little approach. In any case, the decision is entirely up to the central bank.

Where the New Money Ends Up

Once the central bank injects the newly created money into the economy, the money eventually ends up in a commercial banks‘ reserves. Let me give you an overview. The newly created money started at the central bank; then it went into the hands of the owners of the securities that was purchased by the central bank; and then ultimately the newly created money enters the bank accounts of the said owners. So, like I said, the money eventually ends up in the commercial banks’ reserves. Understand? If you’re having difficultly understanding, here’s an easy example.

Example: Sean Adams purchases a government bond so that he can earn interest on his hard earned money. Three years later, Sean sells his government bond at a higher price than what he initially paid for it. The entity Sean sold his government bond to was a central bank. Sean didn’t know he sold his government bond to a central bank, nor does he care. All he cares about is how his investment paid off nicely. The money that Sean received from selling his government bond was some of the newly created money from the central bank; but Sean doesn’t know that. Sean immediately takes his money to his bank and deposits it. The End.

Now think of this on a bigger scale. Instead of just Sean, imagine millions of people doing roughly the same thing. Taking their money and depositing it into their bank accounts. What eventually happens is that the commercial banks will have excess reserves. That means that they can loan out more money because the commercial banks have more money in their possession.

Now if many commercial banks have excess reserves, then all of them will have more money to loan. This creates competition among the commercial banks. To compete, the commercial banks will make the loans more affordable by charging less interest. Businesses and individuals will be more apt to borrow and spend. Businesses will borrow, hire employees, invest and grow. Individuals will borrow, buy cars, buy homes and other major items. All this will help stimulate and grow the economy.

Dangers of Quantitative Easing

Though quantitative easing is has proven to be beneficial and effective in jump starting a faltering economy, there are some dangers in utilizing it. When a central bank creates new money, it essentially devalues the money that was in existence prior to creating new money. The devaluation of money causes the prices of goods and services to increase; that is called inflation.

Quantitative easing can open the door to inflation and cause catastrophic economic problems. Imagine a carton of milk costing you one dollar one moment and through the effects of inflation, that same carton of milk costing you five dollars the next. As you can imagine, it would be devastating if that were to happen to all commonly purchased goods and services. This concept even applies to foreign goods and services; even foreign currencies. When a person has a currency that is being devalued through the implementation of quantitative easing, one will find that goods and services from other countries will start becoming more expensive. That’s why a central bank must be careful when using this tactic to stimulate an economy.

The Benefit of Having a Weak Currency

Inflation is inevitable when a central bank performs quantitative easing. When you continue to create new money, an economy will become saturated with the currency and the value will drop; basic supply and demand. But there is one thing I want to touch on regarding a devalued and weak currency. There is a benefit for making a currency weak. A weak currency can also help stimulate an economy. How? Because we live in a global environment. Foreign countries that do business internationally, which practically every country does, will be more willing to do business will a country whose currency has become weak. Why? Because it make goods and services more affordable for foreign consumers and investors. If it is more affordable to foreign consumers and investors, they will buy more. And if they buy more, it will stimulate the economy. Having a weak currency also forces a country’s citizens to only buy goods and services from inside their country because foreign goods and services will be more expensive.

But like everything in life, there has to be a balance. If a currency becomes too weak, then everyone will sell that weak currency and no one will accept it. If no one accepts it or wants it, the currency will ultimately become worthless. Then you’ll run into major problems.

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