QE

How The Fed Uses Tools Like QE To Prop Up The Economy

In 2008 the government became actively involved in efforts to save the economy, with everything from hundreds of billions in stimulus funding to small-scale “cash-for-clunkers” programs.

One of the most central – and to some, controversial – programs, however, has been the Federal Reserve’s quantitative easing (QE), which until its announced termination in October 2014, had inserted hundreds of billions of dollars into the economy.

But what exactly is QE?

Liquidity trap

Following a financial crisis, investors can lose confidence in the market, meaning that they would rather hold on to their cash instead of investing it.

With less money being loaned out, companies can run out of short-term cash and be required to file for bankruptcy in order to pay their obligations. This is called a liquidity trap, according to Washington University in St. Louis.

In order to avoid this, central banks can buy government bonds from private holders, which increases the amount of money in circulation and decreases interest rates, thereby encouraging investors to invest their money in companies with potentially higher rates of return.

Zero bound problem

Central banks can’t reduce interest rates to less than 0%, however. This is called the zero bound problem.

So in order to encourage lending, central banks have to further increase the money supply, or the total amount of money in circulation. To do this, they engage in quantitative easing.

Basically a way of injecting money straight into the economy, QE involves the central bank “printing” (electronically, not physically) money, then buying short- and long-term bonds from institutions such as banks.

This has two intended effects, according to the Guardian: increasing the money held by banks and corporations, encouraging lending; and reducing bond yield, encouraging investment in other parts of the economy (such as new ventures and the hiring of new staff).

When the economy eventually recovers, the central bank then intends to sell the bonds back to corporations and destroying the cash it receives for them, so that in the long term, no extra cash is added to the money supply, according to the BBC.

Consequences

The final sum, now that QE spending has come to a close, totals almost $4.5 trillion.

While some maintain that the final verdict is still out in regard to QE’s efficacy, it has indeed helped lower interest rates for both American homebuyers and big businesses.

Though done for now in the U.S., the QE train may be far from over. The European Central Bank (ECB) is currently mulling over its own easing program to the tune of $1.1 trillion in the hopes of combatting rampant deflation.

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Ole Skaar