Quantitative Easing

Topics: Monetary policy, Money supply, Central bank Pages: 7 (2348 words) Published: April 17, 2013
1.What is the difference between QE (quantitative easing) and more orthodox open market operations conducted by central banks?

During the period of 1986 to 1991, the Japanese economy was experiencing an economic bubble that was characterized by highly inflated real estate and stock prices. The subsequent effects of the bubble’s inevitable collapse lasted over a decade with the stock prices reaching their lowest values during the year 2003. It was during this recessionary period of the early 2000s that the Japanese government began to purchase long-term government debt from banks as a means to decrease interest rates and to entice more investment and consumer spending; a feat that was somehow next to impossible for the incredibly low interest rates that already existed in the market. This newly engineered process of monetary policy pioneered by the Japanese was given the name quantitative easing. Since its conception, quantitative easing has been used by several different central banks such as the Federal Reserve and the Bank of England during the global financial crisis of 2008. However, despite the popular use of the mechanism, it is important to note that the process of quantitative easing varies greatly from the process of conventional monetary policy and the totality of its affects are currently under heavy debate by academics.

To begin fully understanding quantitative easing and its implications, it may first be easiest to establish what conventional monetary policy is and its purpose. During inflationary and deflationary periods, central banks generally employ conventional monetary policy in order to stabilize the economy. Typically this goal is achieved by conducting open market operations with banks and financial institutions as a means to control the money supply in the economy. During a period of inflation, which is often driven by an excess of loans given out by banks, the central bank will sell short-term government securities to the banks. This in turn reduces the amount of cash banks have on hand and, on an macroeconomic scale, reduces the money supply. The outcomes of this process are increased short-term interest rates that reduce the amount of loans given out and increase consumer savings. The reverse of this procedure occurs during a period of deflation. In this situation the central bank will purchase short-term government securities from banks. As a result of this, banks will have more money on hand and the overall money supply will increase. An increase in the money supply decreases interest rates, which in turn induces businesses to seek more loans and consumers to spend greater amounts and save less. It is important to note, that monetary policy focuses on short-term interest rates as supposed to longer maturity assets (New York Federal Reserve). Although many central banks throughout the world rely on conventional monetary policy to maintain the health of their economies, the mechanism still has its limitations. During severe recessions such as the ones observed by the Japanese in 2001 and the global economy in 2008, the effectiveness of monetary policy becomes less effective as it becomes increasingly more difficult to continue lowering interest rates. The point at which interest-rates can no longer be decreased is known as the “zero bound” (Plumer). Once the “zero bound” is reached governments often begin looking for alternative solutions to the problem at hand. It is at this point that quantitative easing becomes a relevant alternative for central banks.

As a general rule of thumb, quantitative easing is employed by a central bank only when conventional monetary policy’s usefulness breaks down and becomes ineffective. Moreover, another requirement before using the mechanism is that banks are no longer lending to consumers or businesses. The process of quantitative easing begins with the central bank loaning money out to banks at incredibly low interest rates between 0% and .25%. After...

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