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Quantitative Easing in the US: An Introduction


01/07/2013 10:24 (291 Day 18:16 minutes ago)


The FINANCIAL -- When the financial crisis dragged down the world economy in 2007 and 2008, the United States Federal Reserve (“Fed”, the American central bank), did something unprecedented to stimulate the economy: it started buying up trillions of dollars worth of government bonds and mortgage-backed securities, in an effort to lower interest rates in the economy. This was called “Quantitative Easing”.


Now the American economy is doing better, the chairman of the Federal Reserve, former Princeton University professor Ben Bernanke is weighing selling some of these bonds to end the quantitative easing program. In this article, we’ll look at how quantitative easing works, and what some of the risks are. In next week’s article we’ll examine the end of quantitative easing and what it means for the world economy.

In economic theory, when the economy is slumping, the government can attack the problem fiscally or monetarily. If a government uses the fiscal method, it employs some combination of increased government expenditures and reduced taxes to put more money in the hands of corporations and consumers, who will then hopefully start spending money to stimulate the economy. This method is often associated with the British economist John Maynard Keynes.

To put it simply, the monetary method means printing money. While in economics textbooks it is often assumed that the government just drops the money on its citizens, the reality is a little bit more complicated. A country’s central bank (or the Federal Reserve in the United States) will conduct open-market operations, which means that it will buy government bonds (or sometimes other types of bonds). However, it doesn’t pay for this with real money, but with money that it “creates” electronically at the moment of purchase. This is an important fact to realize: when a central bank buys a financial instrument like a bond, often the money didn’t actually exist before. However, once it buys the bond, the money is real. Basically, by buying a bond, the central bank puts money - that didn’t exist before -  in the hands of the person who sold that bond, and hopefully that person will go out and spend or invest that money to stimulate the economy.

However, when the central bank buys a lot of these bonds, something else happens as well: they move the market, or in other words, they change market prices. When there is a lot of demand for something, prices go up. And what happens when bond prices go up? The “yield” (rate of return) on that bond goes down, so it becomes cheaper for the government to borrow. In simple terms, if there is more demand for loans to the government, they will be able to borrow money at lower rates. This is what happened as a result of quantitative easing: in 2007 for example, a one-month loan to the US government would give you a return of approximately 5% per year. Today, that same one-month loan would give you a return of not more than 0.03% per year.

When central banks manage to lower yields on bonds that much, it becomes very unattractive for investors to hold these instruments, and that is exactly what the central banks want: they want investors to go out and put their money in riskier assets that stimulate the economy. These riskier assets could be corporate bonds, stocks, or other investment projects. Central banks assume that if investors will get no return on government bonds, they will go and buy other financial instruments.

The special thing about quantitative easing, as opposed to standard monetary policy that just involves buying and selling short-term government bonds, is that with quantitative easing, the Federal Reserve in the US also buys long-term government debt and even private debt, such as bonds issued by banks, and bonds issued by mortgage agencies. This is done in a general effort to reduce interest rates in the economy.

Of course there are also risks associated with these types of operations. If central banks “print” too much money, this might create inflation, which means that your money loses some of its value. Because interest rates in the economy are lowered, people who save money also lose out, because interest rates on savings account will generally be lower than inflation.

Another risk is that it might create asset bubbles: because government bonds provide very low returns, investors may put their money in other assets that subsequently experience so much demand, that their price increases to beyond what they are actually worth, thereby creating a “bubble”, when prices are no longer based on fundamentals.

In the next article we will look more closely at what consequences quantitative easing has had in the US and around the world, and we will examine the potential ending of quantitative easing and the effects it might have on the world economy. See you next week!





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