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How Does Quantitative Easing Work?

Economy

How Does Quantitative Easing Work?

by | Economy

Ben Constanty

CEO, Smartlink

Disrupting online payments with smart contracts.

Coronavirus is one of the biggest shocks of modern history. Not only is it destroying lives, but its economic aftermath is forcing millions of people out of their jobs across the world.

In order to fend against the economic slowdown induced by COVID-19, central banks around the world are using multiple financial tools to instil growth.

One of the most common economic stimulus options is quantitative easing.

The Bank of England has extended its economic stimulus to over £895 billion in the economy through quantitative easing to mitigate the impact of the ongoing crisis.

This post will explain quantitative easing, how it works, and its benefits, as well as shortcomings.

🔎 Key takeaways

  • Quantitative easing is a financial tool used by central banks to boost economic activity
  • Quantitative easing increases the money supply and lower interest rates
  • If overused, quantitave easing could lead to hyper inflation and economic slowdown

What is quantitative easing?

Quantitative easing is a financial instrument through which central banks pump money into the economy.

These financial institutions purchase long-term securities from the markets, thereby boosting the supply of money within the economy.

Quantitative easing has an inverse impact on interest rates. As the supply of money increases, interest rates go down, allowing banks to lend money at attractive rates.

FED Interest rate compared to M2 Money supply

Federal Reserve website

People take advantage of lower rates and borrow more loans.
In short, the entire economy witnesses a boost in economic activity.

How does quantitative easing work?

  • Central banks purchase government bonds and long-term securities from the open market.
  • Higher demand for bonds pushes their prices up. Since bond prices and interest rates have an inverse relationship, interest rates fall.
  • Lower interest rates or yield makes bond somewhat unattractive to investors (big financial institutions), encouraging them to lend their funds somewhere else.
  • In their attempt to boost yield, banks or financial institutions start lending these funds to businesses and retail borrowers at attractive terms.
  • The entire economy tends to benefit from quantitative easing.

Money printing press

Pros of quantitative easing

  • Affordable credit: Quantitative easing brings down the effective interest rate on most credit products. It means borrowers can avail cheaper home loans, auto loans, or any other type of credit solutions.
  • Higher foreign investments: Quantitative easing lowers the economic value of the domestic currency, which can trigger higher foreign investments. Foreign investors can purchase more shares for the same amount of money.
  • Boost exports: Local manufacturers can benefit from lower export prices because of the devaluation in the domestic currency.
  • Higher money supply: Overall money supply in the economy grows through quantitative easing. It’s an effective way to boost economic activity.

Cons of quantitative easing

  • Higher inflation: A side effect of quantitative easing could be higher inflation. Since the economy is flushed with new money without any organic growth, it could trigger high inflation.
  • Expensive imports: The downside of quantitative easing is expensive imports. As the value of the domestic currency goes down, importers will have to pay more for the same goods.
  • No guarantees of economic activity: Quantitative easing, in principle, should boost economic activity, but there are no guarantees of such an outcome. Central banks cannot force financial institutions to lend more or people to borrow more money.

Summary

Quantitative easing is an effective way of boosting the economy, but it is critical to control its outcome through additional regulations or incentives.

Ben Constanty

CEO, Smartlink

Disrupting online
payments with smart contracts.

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