Quantitative easing is a specialized and unconventional tool or instrument of monetary policy implemented by central banks or monetary authority of a country to inject new money to the economy, lower the cost of borrowing, and “ease” the financial markets to influence economic activity positively.
Origins of this Unconventional Tool of Monetary Policy
The Bank of Japan introduced the term “quantitative easing” in the 1990s to describe a new monetary policy aimed at easing the money supply and addressing deflation in Japan during the era. Specifically, it purchased Japanese government bonds and used them as a main financial instrument for satisfying projections in current account balances held by other banking institutions operating under its regulatory control. The process resulted in the injection of money in banks, thus increasing their available cash reserves.
Providing banks with larger cash reserves promoted private lending that, in turn, increased the money in circulation. Note that growth in the money supply can help address deflation. After all, based on the monetarist school of economics, excessive growth in the money supply can result in inflation. Japan used quantitative easing to salvage the weakening Japanese economy due to the bursting of its real estate bubble and the subsequent deflationary pressures during the 1990s
The United States government has also been implementing qualitative easing in several instances to address economic downturns, such as during the 2007-2008 Financial Crisis. It is also worth mentioning that even before Japan introduced and formalized the concept, the U.S. Federal Reserves implemented measures similar to the modern principle of quantitative easing during the Great Depression of the 1930s. The concept has now become a tool of monetary policy.
Understanding the Definition and Purpose of Quantitative Easing
Remember that monetary policy is an economic policy and macroeconomic tool utilized for stimulating economic growth or driving economic contraction by controlling the supply and availability of money in circulation, as well as by influencing the interest rates of commercial banks and other similar financial institutions.
There are three established instruments or tools of monetary policy. These are the reserve requirement, the discount rate, and the open market operations. To understand the definition, principle, and purpose or usefulness of quantitative easing, it is important to take note that it is somewhat related to open market operations.
Central banks or monetary authorities can directly control the money supply and indirectly manipulate commercial interest rates either by buying or selling different financial instruments such as government bonds and treasury bills to supply banks with liquidity or take surplus liquidity from them. This is called open market operations. Quantitative easing is similar in principle.
Quantitative easing specifically involves a central bank or monetary authority buying predetermined amounts of government bonds or other financial assets to inject more money in circulation and positively influence economic activity. Considered as an unconventional monetary policy, it is a measure used to either address low inflation rates or deflationary pressures, or when standard expansionary monetary policy has become ineffective.
For a simpler description, the principle is somewhat akin to producing money. However, instead of producing actual legal tenders such as coins and notes, a central bank buys financial assets or debts such as government bonds and treasury bills, as well as securitized mortgages and other financial assets of banking and financial institutions in exchange for producing and handing out cash.
More on the Difference Between Open Market Operations and QE
Despite some similarities between open market operations and quantitative easing, there are still considerable differences between the two. OMOs are collectively part of the normal cash operations of a central bank. Qualitative easing is an expansion, albeit targeted and specialized part of the open market operations.
The purpose of open market operations is to either supply commercial banks with liquidity or take surplus liquidity from these banks, as well as to indirectly control the total money supply by manipulating the short-term interest rate and the supply base of money. The objective of OMOs depends on whether the economy requires expansionary or contractionary measures.
On the other hand, the focus of qualitative easing is more on injecting money directly to the economy by purchasing government bonds or treasury bills, thus effectively handling money to the government, or by purchasing financial assets from commercial banks or other private institutions to raise the price of those assets and lower their yields while increasing the money supply at the same time. It is essentially a part of expansionary monetary policy with the objective of responding to the expansionary requirements of the economy.
It is also radical in principle. In some dire situations, a monetary authority also attempts to increase confidence in the financial markets by buying toxic assets. An example would be the Federal Reserve buying a trillion-dollar worth of mortgage-backed securities during the Financial Crisis of 2007 and 2008.
Relationship of Quantitative Easing to Other Expansionary Economic Measures
It is critical to highlight the fact that a monetary policy often goes alongside a fiscal policy under a Keynesian economic inclination. Note that classical economics maintains that the economy is self-regulating. However, Keynesian economics argues that the economy cannot regulate itself, and as such, the government needs to intervene through fiscal policy and monetary policy.
Both fiscal and monetary policies take the expansionary route during an economic recession or limited downturns in the economy or selected markets. In the case of a monetary authority, it utilizes the different instruments or tools of monetary policy to expand the money supply and stimulate money in circulation to apply downward pressure to interest rates, encourage borrowing-lending activities, and promote consumption.
Quantitative easing comes into the picture as an unconventional measure when all other instruments of expansionary monetary policy have become ineffective. Remember that it is similar to the standard open market operations, but it is more expansive and considerably radical. It essentially allows the creation and injection of new money in the economy, lowers the cost of borrowing and lower the yields on financial assets to influence low commercial interest rates and encourage commercial lending-borrowing activities, and ease the financial markets to stimulate financial activities and the economy as a whole.
It is also interesting to note that quantitative easing can help the government pursue an expansionary fiscal policy. A monetary authority can simply purchase government bonds and treasury bills to provide the government with the cash needed to stimulate the economy via public consumption. In addition, because of its effect on lowering the cost of borrowing and the yields on financial assets, it allows the government to borrow more money for stimulus.
There are some reservations and criticisms toward this unconventional instrument of monetary policy. Some argue that it is ineffective because it simply increases the amount of excess reserves in the entire banking system. Banks might opt to hold on to these cash supply instead of lowering interest rates and encouraging widescale lending-borrowing activities.
Furthermore, it is also possible to encourage irresponsible banking activities. Banks might become too lenient in extending banking services, especially lending and credit services to individual and business consumers.