Understanding Quantitative Easing
To execute quantitative easing,
central banks increase the supply of money by buying
government bonds and other securities. Increasing the supply of money is similar to increasing supply of any other asset—it lowers the cost of money. A lower cost of money means
interest rates are lower and banks can lend with easier terms. This strategy is used when interest rates approach zero, at which point central banks have fewer tools to influence economic growth.
If quantitative easing itself loses effectiveness,
fiscal policy (government spending) may be used to further expand the money supply. In effect, quantitative easing can even blur the line between monetary and fiscal policy, if the assets purchased consist of long term government bonds that are being issued to finance counter-cyclical deficit spending.
The Drawbacks of Quantitative Easing
If central banks increase the money supply, it can cause
inflation. In a worst-case scenario, the central bank may cause inflation through QE without economic growth, causing a period of so-called
stagflation. Although most central banks are created by their countries' government and are involved in some regulatory oversight, central banks can't force the banks to increase lending or force borrowers to seek loans and invest. If the increased money supply does not work its way through the banks and into the economy, QE may not be effective except as a tool to facilitate deficit spending (i.e. fiscal policy).
Another potentially negative consequence is that quantitative easing can
devalue the domestic currency. For manufacturers, this may help stimulate growth because exported goods would be cheaper in the global market. However, a falling currency value makes imports more expensive, which can increase the cost of production and consumer price levels.
Is Quantitative Easing Effective?
During the QE programs conducted by the
U.S. Federal Reserve starting in 2008, the Fed increased the money supply by $4 trillion. This means that the asset side of the
Fed's balance sheet grew significantly as it purchased bonds, mortgages, and other assets. The Fed's liabilities, primarily
reserves at U.S. banks, grew by the same amount. The goal was that the banks would lend and invest those reserves to stimulate growth.
However, as you can see in the following chart, banks held onto much of that money as excess reserves. At its peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome for the Fed's QE program.