Monday, March 30, 2015

Macroeconomics primer: How quantitative easing affects loans, cash, investments and the economy


Quantitative easing can be defined as the introduction of new money into the money supply of an economy. In a central banks’ balance sheet, it has the option of either purchasing or selling government bonds in the open market. Rather than utilize this traditional monetary option, the central bank decides to buy the bonds of banks and debt instruments of other corporations.

Learning doesn't end.
Credit: Diego Muller on Flickr

Why implement quantitative easing

When the economy is in a crisis and the conventional attempts to revive it using monetary or fiscal policies have failed, the central bank might be called upon to experiment with a quantitative easing.

As the central bank buys corporate bonds and assets, the prices of these instruments rise while their yields fall. Therefore, the cost of borrowing for businesses and households falls. It is expected that when the banks and other financial institutions lend these money, investments will increase.

These fall in cost of borrowing and availability of easy money for lending increases liquidity in the economy. Liquidity refers to the availability of liquid cash in the economy. As we know, cash is an engine for activity. Availability of these cash is expected to revive the already comatose economy.

On the consumers’ side, there is much money to buy new houses and non-durable goods like cars, toys, computers, laptops, video players etc. Therefore, demand on the aggregate in the economy is expected to rise.

This expected rise in aggregate demand makes businesses borrow money in order to anticipate high demand for their products. Therefore, competitive pressures increases and many companies reduce the prices of their goods in order to gain market share and make more profit.

Eventually, when businesses start making profits, employees or workers start asking for an increase in salary. Eventually, producers raise their prices in order to meet up with the increased wages they are paying and prices rise again. Employees once again ask for higher salaries and to meet up the demand, producers increases the prices of their goods. Eventually, the increase in prices is expected to stabilize.

Therefore, inflation, a general increase in prices and fall in the purchasing value of money, is what central banks expect when quantitative easing programs are introduced.

The above scenario is what makes the economy vibrant after it has been tepid following a financial crisis.

But sometimes it doesn’t work out as in a fairy tale!

Sometimes, it doesn’t work out as calculated.

  1. Cash hoarding:

  2. Instead of spending the extra cash in their hands, businesses and households might decide to hoard it. That is, they might decide to amass it. Don’t blame them. After going through a financial crisis where money is hard to find, having easy money is too good to be true and losing it becomes a difficulty. When cash is hoarded, the economy finds itself in a liquidity trap. The expected increase in demand does not kick off.

  3. Inequality increases:

  4. It might increase inequality in the economy. The rich in any economy own more stocks and shares; they own more property like houses; they have access to bonds and corporate debt instruments. As the prices of these items increase, their wealth increases, increasing the inequality gap in the country.

  5. Extraneous factors:

  6. If eventually fall in prices is not in response to quantitative easing but due to something else, like a fall in the prices of commodities or resources used in the production process, inflation, or the increase in prices as predicted by the central bank, might not really be boosted. Instead, the existence of easy money might cause deflation, a reduction in the general level of prices, rather than inflation.

Overall, quantitative easing is introduced by central banks only when all other conventional monetary policy options have failed or will fail.


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