What is Quantitative Easing?

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Quantitative easing, known as QE, is a monetary policy used by a central bank to increase the money supply by increasing the excess reserves. In layman’s terms, they inject a lot of new money into the money supply through open market operations. If this sounds like the central bank is just printing more money, you’re right (technically they just make up money out of thin air electronically, no actual printing is necessary). The specifics of how they do this are probably not important to 99.99% of us, but they’re explained below, but what is important is why a central bank like the Federal Reserve would want to do this.

How is QE accomplished?

(in case you were curious) The central bank essentially credits its own account with new money and uses that money to buy assets from banks, thus increasing the reserves at those banks. Those banks can then lend that money out at a multiple based on the reserve ratio. If the ratio is 10%, then they can lend out 90% of the amount of the added reserves. Reserve ratios are the percentage of an asset they must keep as reserves (so if you have $100 and the ratio is 10%, you can lend out $90). The next bank can lend out $81, keeping $9, and so on and so forth.

Why do they use QE?

As you may be aware, the current federal funds rate is remarkably low – target is 0 – 0.25%. If additional stimulation is needed, they can’t exactly lower the federal funds rate to under 0%, then banks would be paid to borrow money from the Fed (and they would borrow an infinite amount!).

Quantitative easing is just another monetary policy tool they can use to inject money into the money supply to spur lending and boost the economy.

What are the risks of QE?

The biggest risk is hyperinflation, as it’s happened in a variety of places. Whenever you print more money, you devalue existing money since the underlying characteristics of the economy have not changed. Simplistically, if your economy is worth $1000 and you have 1,000 bills, each one is “worth” $1. If you print 1,000 more bills, each one is really worth just $0.50. In enormous economies worth trillions of dollars, the degree to which you print more money has the effect of nudging the economy in certain directions. The risk is that a nudge becomes a push or even a shove… down a hill. (Think: 1920s Germany following World War 1 and Zimbabwe in the early 2000s)

There you have it, quantitative easing in a nutshell.

{ 20 comments, please add your thoughts now! }

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20 Responses to “What is Quantitative Easing?”

  1. yakov says:

    If I could borrow money at 0% interest, and I had reason to believe that the money would soon be worth a lot less (due to QE) then I would also buy an infinite amount and buy a lot of oil.

  2. Hal (GT) says:

    And the result is going to be a currency war. One of the reasons, too, that Jim Sinclair says gold is going to the moon.

  3. I’m sorry. I guess my little mind just doesn’t get it. Isn’t this at least partly how we got into this mess?!

    • NateUVM says:

      Perhaps I don’t understand your question enough (what is “this”?), but no. What people are now calling Quantitative Easing is just another monetary tool (the selling and, in this case buying, of Treasuries) that the Fed has at its disposal. A tool that it has had for a long time and has used before.

      It is in no way related to the sub-prime mortgage or subsequent credit crises. That had to do with massive over-speculation and a complete lack of appropriate corporate oversight.

      I’m sure there was a LOT more to it, but it didn’t have anything to do with this tool of the Fed’s.

      • This tool of the Fed causes over-speculation. Fed policies did contribute to the housing bubble and subsequent crash.

        • NateUVM says:

          It’s true that this type of move would encourage investment….this IS a tool that they have historically used when the economy isn’t growing fast enough (e.g. when inflation is too low).

          More specifically, I’m pretty sure that the Fed wasn’t purchasing billions of dollars worth of Treasuries in the pre-crash frothiness of the market. “QE1,” as it were, wasn’t until after the market started its downturn. Maybe I’m wrong, but can you point to any evidence that wasn’t the case?

          • Jim says:

            QE1 happened after the federal funds rate was pegged at 0-0.25%. QE is usually only used after interest rates can no longer be fiddled with.

        • Jim says:

          Josiah, your two sentences are about two separate points. QE doesn’t necessarily cause over-speculation, it boosts the money supply and, in theory, should entice businesses to invest.

          As for housing bubble and crash, a lot of things contributed to that including investment banks trading their own accounts, Fannie & Freddie buying every mortgage under the sun, and low interest rates.

        • That’s what I thought….

          • I mean about these ‘tools’ being at least a part of over speculation.

          • NateUVM says:

            But that’s not true. This particular tool is typically only used when there is a complete LACK of confidence in spending (i.e. lack of over-speculation). I do not know of an instance where that hasn’t been the case.

  4. FlyFisher says:

    We have been going down a pretty slippery slope with QE, Keynesian Economics from the legislature and president, and way too much uncertainty.

    Not the approach I would have taken.

    • NateUVM says:

      …which is why these actions are being taken. To take away the uncertainty and return the economy to one of more predictibly steady growth.

  5. INDEPNMS says:

    From what I understand a good portion of businesses both large and small actually have large amounts of cash on hand. In many cases it is not a matter of needing more cash. The uncertainty concerning their increasing tax burden, over-bearing regulation and documentation requirements, not to mention the unknown cost complexity of ObamaCare, have caused many businesses to draw back and consequently “sit” on there cash. The other effect is decreased payrolls which in turn affect the consumer confidence and availble money in circulation. We do not need QE2. We need the certainty of the “Bush” tax cuts being extended to EVERYONE regardless of their position on the economic ladder. One of the major risk of QE2,inflation, could be mitigated by a major reduction of federal spending and a guarantee to not raise taxes. We are concerned that QE2 could have a serious inflationary effect especially as we currently see an entrenching of consumers towards the “stables” of existence in this economic downturn. We do not need to agitate the situation with a further devalued currency.

    • REAL INDEPIL says:

      (a) Bush tax cuts are in effect and we has the Great Recession and the middle class got huge tax cuts with the stimulus

      (b) Company’s are sitting on cash to take advantage of the coming consolidation as well as productivity is still higher than it was

      (c) if you want consumers to have money on circulation, why you against stimulus money, goes straight to the people WHO SPEND IT

      You’re grade school needs better econ courses.

      • markit8dude says:

        -‘..middle class got huge tax cuts..’ – are you referring to the extra ~.50 cents per day? Wow, ‘thanks’!

        The tax cuts for the higher income earners need to be extended. Unless you know a lot of poor people who provide jobs..

        -Companies (it’s ‘ies’ not ‘y’) are sitting on their investment because this current Congress is removing capital from our market.. duh.

        Furthermore, the ‘small business loan bill’ has few takers. Why? Because the banks ALREADY have enough capital and don’t need this dangling carrot to provide loans, not to mention they don’t want to be in further in the Fed’s pocket.

        -Regarding your ‘productivity’ comment – please provide the data for such a claim.

        -The ‘stimulus’ money has neen a big slush fund, a PAYOFF to the Unions, public and Government sector for their campaign monies.. i.e. private sector money that was steered to them in the first place!

        The silly ‘this construction site provided by the Stimulus..’ signs across the country are SOLELY for the construction/union types.

        The NEA (teacher’s union) just got that $60 + billion ‘stimulus’ so we won’t be short teachers. Never mind recently the 600 Houston, TX teachers who haven’t worked the entire school year but are getting paid full pay.. again the NEA bill is a joke.

        -Lastly ‘REAL INDEPIL” – please don’t attempt to talk down to people when using ‘You’re’ i nyour unfounded smugness.. ‘You’re’ a buffoon. See, I used it correctly..!

    • Scott says:

      If what you mean by “cash” is money in their savings accounts, than yes you are right, businesses needing more “cash” is generally not the problem. On the other hand, if what you mean by “cash” is spendable money available for businesses to run their operations and pay their employees, then you are wrong businesses do need more “cash”.

      This spendable money that businesses need to operate doesn’t come from their savings accounts it comes from loans they obtain through banks. The problem is that banks are not giving businesses these loans right now because of a pesky little thing called the credit crisis which was caused in large part by the over-speculation of the housing market and defaults on sub-prime mortgages. This is where QE comes in.

      When credit is hard to get and money isn’t circulating like it needs to in order for markets to work, the FED will often lower interest rates in order to encourage lending and unfreeze the credit market. However, current interest rates are as low as they can go so the FED is using its other monetary tool called quantitative easing. QE isn’t the FED just creating money out of thin air and giving it to banks. It is, in essence, a process by which the FED liquidates assets in the financial market by purchasing government securities from banks. The reason for doing so being that with more spendable money in the market, banks will be less afraid of lending and the money will begin to circulate again.

      That being said, I can see how blaming the recession on things such as the taxing and regulation of certain types of business can be politically convenient for some people. The idea that the solution is to renew the Bush tax cuts and reduce federal spending is also is also falsehood which is based more on ideology than economic theory. The fact is that continuing the Bush tax cuts will only serve to make the problem worse by increasing the debt by estimates of up 2 trillion. As for federal spending, because the amount of money that was taken out of the economy when the housing market collapsed was so enormous, only the federal government has the ability to spend enough to offset that loss of consumption which is what will be necessary to return the economy to a stable equilibrium.

  6. corey says:

    The road to Weimar is riddled with naivety.

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