As the Feds (US central bank) announce the end to their third Quantitative easing program (QE3) questions aroused regarding whether the QE program actually worked in stimulating economic growth and how it worked. Experts and even Fed officials are divided in answering this with some claiming it was a major factor contributing to the USA’ s recent economic recovery and others claiming that it was a nonevent and had little influence on the economy and it may even be detrimental in the long term to the economy. With the Bank of Japan quickly following the Feds’ suit and the European Central Bank considering implementing QE, is it worth doing or should central banks focus on more conventional monetary policies such as ultra low interest rates.
Quantitative easing is when the central bank purchases government assets (usually government bonds) with the aim of lowering interest rates and increasing the money supply in the economy. It starts with the central bank buying government bonds from financial institutions with electronically created money. This increases the banks’ reserves thus banks become more inclined to lend money to the public and firms which increases consumer expenditure and investment leading to economic growth. Moreover studies suggest that QE has a secondary effect in increasing bond prices. As the Fed bulk buys long term government bonds, the supply of these long term bonds decreases thus driving its price up. As the price of government these bonds increases, the longer term borrowing rates of these bonds decrease which further stimulates investment and growth.
Although there is a lot of evidence supporting the success of the QE program such as solid growth posted by America in the last two quarters (4.0%, 3.5% real GDP growth) and recent positive employment figures, many analysts believed when QE started that it would actually be dangerous in the long run. They believed that implementing quantitative easing would cause exponential inflation as consumers would have more money to spend and firms would have more money to invest thus resulting in an increase in aggregate demand causing demand pull inflation. However these critics failed in analysing the intricate mechanisms of QE. When the Feds bought government bonds from banks etc it swapped them with the bank’s reserves. This therefore results in no change in the net worth of the private sector thus it doesn’t cause inflation.
Moreover it has a positive psychological effect on consumers. Further implementation of QE is often followed by a rise in the stock market causing a positive wealth effect which would also greatly aid the economic recovery.
In conclusion, although QE doesn’t change the net worth of the private sector (as above) what it does serve to do effectively is liquidate banks thus it helps increase lending and stimulates economic growth. Furthermore the effect on bond prices and stock markets makes QE worth a try for central banks who have run out of ideas regarding monetary policy.
