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What is Quantitative Easing?

Posted By Jim On 11/02/2010 @ 7:08 am In Government | 20 Comments

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 [3] is remarkably low – target [4] 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 [5] 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 [6])

There you have it, quantitative easing in a nutshell.


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[1] Tweet: http://twitter.com/share

[2] Email: mailto:?subject=http://www.bargaineering.com/articles/quantitative-easing.html

[3] federal funds rate: http://www.bargaineering.com/articles/federal-funds-rate-vs-federal-discount-rate.html

[4] target: http://www.federalreserve.gov/monetarypolicy/openmarket.htm

[5] Quantitative easing: http://www.currencies.com/qe2/

[6] Zimbabwe in the early 2000s: http://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe

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