Quantitative Easing – An Overview

Quantitative easing is often described as simply, “printing money”. While it does not involve actually firing up the printing presses, it has the same effect: It increases the amount of cash on the market and in the economy.

Quantitative easing is used by central banks like the Bank of England in the UK and the Federal Reserve in the US. It is a last-resort tool employed by these powerful government institutions which is used to stimulate a nation’s economic activity.
Quantitative easing rarely occurs, and is done only in dire situations. Being a last-resort method of stimulating an economy, it only happens when interest rates are extremely low or are at zero.
In other words, central banks will use this form of monetary expansion only after they have failed to stimulate the economy the conventional way – by dropping interest rates.

In all likelihood, the central bank and government will have done many other things to revive the economy as well. These could include fiscal easing (lowering taxes so companies and individuals have more to spend and can hire more people), social programs like increased unemployment benefits, and various other types of stimulus packages.

As we mention in our June 20, 2009 article, quantitative easing could also be used to actually cause inflation and inflate away a government’s massive public debt.

This is certainly not a good practice because all that public debt is money owed to the people in the form of government bonds and Treasury Bills. It would be a selfish way of getting out of debt, as it would be at the people’s expense.

The long-term effects of this would be terrible – the currency would be devalued making its people poorer, and the nation’s purchasing power would be diminished.

But quantitative easing can be done on a small scale, as one of the aids to jumpstarting an economy, without serious long-term effects.

Here is how it works: The central bank of a country will buy various bonds and other financial assets from banks. However, the money it uses is not cash it has recently printed. In fact, no money actually changes hands.

The effect is that banks can lower their reserve requirements (they don’t have to keep as much deposits in reserve versus how much they lend). This is what is meant by ‘easing’. Banks have less pressure to hold more money in reserves.

The concept of deposit multiplication means that if a bank holds $1,000 in deposits it could loan out $10,000 if the reserve requirements were 10%. So it has multiplied the amount of money by ten times. A 5% reserve requirement would mean money would be multiplied by 20 times.

In mid-2009, the reserve requirements of the UK were 0%, the Eurozone 2%, India 5%, US at 10%, China 15.5%, Hong Kong 18%, Tajikistan 20%, and Suriname 35%. In 1978, Turkey was at a massive 62.7%.

Notice that the UK is in a particularly difficult position, with no reserve requirements and an interest rate of only half a percent. The Bank of England’s tools have been all used up. And obviously it is much harder to increase reserve requirements than it is to decrease them.

The risk of low reserve requirements is bank runs. If the economy crashes depositors may panic and rush to the bank to collect their funds.

Imagine all of a bankss customers trying to collect $10,000 when the bank only has $1,000 in its vaults.

In conclusion, quantitative easing is an effective way of multiplying the funds on the market, due to deposit multiplication.

The risk of quantitative easing is that inflation, or even hyperinflation, will ensue if it is used injudiciously.

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