Introduction
Quantitative easing is an unconventional expansion monetary policy which involves the central bank purchasing certain amounts of government bonds or other financial assets with the objective of stimulating the economy as well as liquidity. Standard monetary policy is expected to control inflation in order to ensure that it is at the desired level. Too high or too low inflation rates are not good for the economy. However, the standard monetary policy may not be effective in combating low inflation rates and as such; the central bank opts for this unconventional way of solving the problem. When money supply is high, the rate of inflation also goes up and when money supply is low, the inflation rate also goes down. Through buying government bonds, the central bank effectively increases the amount of money that is in circulation and thus increases the rate of inflation. The central bank undertakes this process through the purchasing of predetermined amounts of financial assets from the commercial banks ( Klyuev, De Imus & Srinivasan, 2009). Consequently, this will lead to the increase of the financial assets’ prices and the decrease of their yield/interest rates, increasing money supply in the economy. The aim of Quantitative easing is to boost the economy through increased spending.
The Process of Quantitative Easing
Under the usual expansion monetary policy, the central bank buys and sells government bonds through the open-air market so as to attain a certain level of interbank interest rates. When interest rates are high, the central bank buys the government bonds from the market which lowers the rates (Prosser, 2014). When the interest rate is low, the central bank sells the government bonds, which increases interest rates. Through this process, the central bank is able to contain the interest rate at desirable levels. However, the central bank may buy the government bonds to lower interest rates and reach very low levels but still, the rate of inflation continues to be low. The central bank will no longer use this strategy since it is not working. At this point where further lowering of interest rates does not bring about desirable results and the central bank can o longer reduce the interest rate, the economy is said to have reached a liquidity trap (Prosser, 2014).
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Liquidity trap happens during recession and depression periods. At this point, the central bank resorts to buying financial assets without the consideration of interest rates in order to stimulate the economy. This strategy is implemented as the last resort in the government’s initiative to stimulate spending within the economy ( Klyuev et. al., 2009). The central bank thus purchases a predetermined amount of bonds as well as other available financial assets from commercial banks. By doing so, the central bank is providing the commercial banks with excess reserves. Banks will lend out money depending on the available reserves that they hold. When they have excess reserves, they will lend out more money in the form of loans. When the reserve levels are low, they will reduce the amount of loans that they offer out to the public (Prosser, 2014).
The aim of the central bank is to provide excessive reserves to these banks so that they can loan more money to the public. As such, this will increase the money supply within the economy. This strategy follows the typical laws of supply and demand. When central bank purchases financial instruments from the financial markets, it reduces their supply within the market and they become scarcer. This increased scarcity will increase their prices in the market, lowering their yield which is the interest rate. Alternatively, when the central bank sells these financial instruments, particularly as government bonds, it increases their supply within the market. The increased supply lowers their prices which increases their yield/ interest rate. Quantitative easing can only be effective in countries which have full control of their currencies. Countries which use regional currency such as the case in the Eurozone, the strategy can only be applicable at the regional and not the country level (Prosser, 2014).
Application of Quantitative Easing
Many countries have applied quantitative easing as a measure to boost their depressed economies. During the Great Depression in the 1930s, the US Federal Reserve applied quantitative easing to boost its economy. In early 2000, quantitative easing was implemented by the Bank of Japan (BOJ) by providing excess liquidity to commercial banks which enabled them to have minimized liquidity risk which promoted private lending. The bank bought government stocks in excessive quantities together with asset-backed securities as well as equities. It also increased the terms of its commercial papers so that the money would stay longer in circulation. This policy worked for Japan as it boosted the economy through increased spending and increased the rate of inflation to the desired levels. Following the 2007-2008 global financial crisis, many countries adopted similar policies including the United States, United Kingdom as well as the Eurozone. These countries opted for quantitative easing when their risk-free short-term nominal interest rates were too low and approaching zero (Hausken & Ncube, n.d).
Economic Implications of Quantitative Easing
Major developed countries have been adopting quantitative easing since 2000s (Welfens, 2010). Studies by the International Monetary Fund (IMF) have confirmed that these initiatives have been indeed very successful in boosting the economies of the respective countries. Studies indicate that these measures have greatly assisted in reducing systemic risks that emerged as a result of the bankruptcy of the Lehman Brothers under the financial crisis that occurred in the late 2000s. It also helped to enhance the market confidence and greatly assisted the G7 economies during the recession which occurred in the second half of 2009. Economists have reported that quantitative easing by the US Federal Reserve has significantly contributed to the country’s economy by lowering interest rates for corporate bonds as well as mortgage rates which have aided in supporting house prices. It has also resulted in higher stock market valuation by increasing the Price: Earning ratio for S&P index. It has also improved the rate of inflation, boosting investors’ confidence for higher rates in the future. The rate of employment is also said to have increased together with the GDP growth. After the global financial crisis, several studies were conducted with respect to quantitative easing. The findings showed that long-term interest rates on many securities as well as credit risks had been lowered following large-scale asset purchases which characterized the initiatives taken to boost the economy. Generally, inflation was slightly increased and the GDP growth enhanced (Welfens, 2010).
According to Welfens (2010), the other economic impact of quantitative easing is experienced on the country’s exchange rate. When this strategy is undertaken, it effectively increases the money supply within the economy. According to the law of supply and demand, when an economic resource is in great supply, its price is lowered. When it is in short supply, the price goes up. Currency also behaves like other economic commodities which are in scarcity. When a particular currency is in great supply relative to other countries’, its exchange rate tends to depreciate. This lowering of the exchange rate happens through the interest rate mechanism whereby, as the exchange rate goes down, the interest rate also goes down. When the interest rate of a country is low, investors do not get the required rate of return on their investments. As a result, they have to invest their capital in other countries where the interest rate is high. This leads to a capital outflow from the country which results in the reduction of the foreign demand for the country’s currency. This makes the currency to be weaker relative to other currencies. As such, it becomes very expensive for importers to trade as they require foreign currency which is expensive while for exporters, trade becomes cheaper as they get foreign currency which is more valuable. Debtors also benefit as the decreased interest rate means that they will pay back less money. Creditors will suffer as they will have to receive less interest amounts from their debtors.
Quantitative easing helps in controlling a falling money supply within the economy. For those countries which apply the fractional reserve monetary system, there is need for a balance between repayments of bank loans and new credit being advanced by the banks. When new credit exceeds loan repayments, it entails that more money is released for circulation as compared with money that is taken away from circulation. This will have the effect of increasing the overall supply of money within the economy. On the other hand, when loan repayments exceed new credit, it will mean that more money is being taken away from circulation as compared to money being released out. This situation will result to an overall decrease in money supply. Quantitative easing ensures that the central bank releases more money into circulation through the purchase of financial assets, which effectively increases the supply of money within the economy (Welfens, 2010).
Risks of Quantitative Easing
Chesnais (2016) points out that the operation of quantitative easing is such that it is aimed at boosting the economy through increased spending. Increased expenditure raises the rate of inflation which is also the objective of this strategy. However, inflation is desirable only up to a certain level. When inflation is too high, it harms the economy through increased prices. If the predetermined amount of financial instruments is overestimated, it will result in a higher rate of inflation than the required level, leading to too much money in circulation. Again, the objective of central bank to purchase financial instruments from the commercial banks is to ensure that they have excessive reserves from which they can increase their loaning capacity to the public. For this reason, this strategy can only work if the commercial banks respond positively. If the banks do not lend out the excess reserves, the strategy will not work as this money will not be released out to circulate within the economy. If economic growth will match the rate of inflation, the currency value will also increase. However, if banks hoard the excess reserves and release them later, it may result to inflationary pressures.
Quantitative easing may also negatively affect the value of savings and pensions (Chesnais, 2016). According to Chesnais, low government bond interest rates that have been artificially induced through this strategy will have unfavorable implications on the underfunded pension funds. This is because the increased money circulation may lead to inflation without corresponding returns. As a result, it will eventually erode the value of savings in the future instead of increasing it (2016).
The central bank does not give strict directives that excess reserves must be lent out locally to businesses and households. Commercial banks thus have the option to invest in other assets such as commodities, commodity-based economies, emerging markets, and other non-local businesses. This entails capital flight, and the government will not have achieved its objectives as the public continues to suffer under low monetary circulation (Chesnais, 2016).
Conclusion
Countries use various monetary policies to control their economies. Sometimes these standard policies do not yield the desired results and the economy continues to experience the same problems. In such situations, the government may turn to other unconventional measures in order to find a solution to their economic problems. One of such unconventional strategies entails the application of quantitative easing as a measure to stimulate spending within the economy. Experiences from countries like Japan, Europe, and the United States of America indicate the effectiveness of this strategy. However, at times, inappropriate estimations may lead to undesired results of over inflation which is also detrimental to the economy.
References
Chesnais, F. (2016). Finance capital today: Corporations and banks in the lasting global slump . Brill Academic Pub.
Hausken, K., & Ncube, M. (n.d.). Quantitative Easing and Its Impact in the US, Japan, the UK and Europe . Springer
Klyuev, V., De Imus. P., Srinivasan, K. (2009). Unconventional choices for unconventional times: Credit and quantitative easing in advanced economies . Washington, D.C.: International Monetary Fund.
Prosser, T. (2014). The economic constitution . Oxford University Press.
Welfens, P. J. J. (2010). Innovations in macroeconomics . Heidelberg: Springer.
