What is Quantitative Easing and what are its effects on economy?
In this blog, we will discuss what exactly is quantitative easing? This term became quite popular after 2008 financial crisis. In the recent times as well , central banks all over the world have undertaken quantitative easing to boost the economy.
What is Quantitative Easing?
- Before getting to know what exactly is Quantitative easing, let us find out why and when exactly quantitative easing is undertaken? These measures are carried out by the central bank of any country as a part of its monetary policy. In case of India, RBI carries out quantitative easing.
Types of Monetary Policies
- There are basically two types of monetary policies – expansionary monetary policy and contractionary monetary policy.
- With the help of these policies a central bank keeps the inflation under check. Let us see how with the help of two scenarios as follows.
Contractionary Monetary Policy
- Scenario 1: When the economy is booming, discretionary incomes of people increase. This leads to increased spending, which in turn increases the demand. Now when the demand increases but supply does not increase at the same pace, prices go up. Increasing prices lead to inflation rising beyond target inflation level. This creates an inflationary pressure.
- So to tackle this inflationary pressure, here central bank increases the interest rates. This leads to lesser cash to spend in people’s hands, leading to lower spending. As spending decreases, demand decreases. However, supply does not decrease at the same rate. This leads to higher supply and lower demand, which ultimately leads to lower prices. Thus, inflation level falls to its target level.
- This kind of monetary policy which decreases the money supply in economy is called as contractionary monetary policy.
Expansionary Monetary Policy
- Scenario 2: This scenario is exactly opposite to scenario 1, when the economy is not in a good shape. Here, discretionary incomes in the hands of people are lesser. This leads to decreased spending, which leads to decreased demand. When demand decreases, but supply does not decrease at same rate, prices of products start falling. This leads to inflation levels lower than target levels and results in sluggish economy.
- To revive the economy, central bank decreases the interest rates. This encourages lending and investment activities, leading to increased cash in the hands of people. People start spending more which leads to increased demand. Increased demand raises the prices of the products and inflation is at healthy level. Thus, economy starts reviving.
- This type of monetary policy which increases the money supply in economy is called expansionary monetary policy.
- To execute these monetary policies, central bank takes help of various tools like increasing/decreasing interest rates, open market operations, changing the reserve requirements of banks, etc.
- We have seen how increasing/decreasing interest rates helps in keeping inflation under control.
- However, when interest rates are already at lower levels, they cannot be further declined. During such times, central bank resorts to other tools like open market operations.
- Under open market operations, central bank buys/sells government securities in open market to adjust the money supply. Quantitative easing is a part of open market operations.
- Quantitative easing is basically a process in which central bank buys long-term government bonds from open market which includes banks, financial institutions, government entities, etc. Buying these securities from the open market, pumps money supply into the economy. This leads to increased lending and investment activities in the economy, ultimately stimulating the otherwise sluggish economy.
- Due to the financial stress created by the pandemic, we can see almost all the central banks undertaking quantitative easing to boost the economy. Overall central banks across the world have pumped ~ $8 trillion in the world economy during this pandemic.
Effects of Quantitative Easing
- One of the impacts of quantitative easing can also be the increased retail participation in the markets which is evident recently from the increasing inflows. Increasing retail participation stabilizes the asset prices and thus induces a “feel good” factor in the economy, leading to euphoric reactions by market participants.
- Another possible impact of quantitative easing is rather an unfavorable outcome. This is increasing inflation levels without stimulating the economy, which results in an economic condition called stagflation.
- In stagflation economy faces higher than normal inflation levels but slower economic growth.
- In such a situation, it is said that the quantitative easing has failed to achieve its desired outcome and central bank might opt other techniques like changing reserve requirements, etc.