Quantitative easing (QE) describes a process that central banks use to increase the domestic money supply. It is widely believed to be the largest monetary experiment the world has ever known.
We at Collective Shift strongly believe that you should spend time learning about QE and its implications on financial markets, the economy, and society at large.
So, we know QE is something central banks can implement to increase the domestic money supply. There’s a bit to untangle here, so let’s break it down below.
- Central banks are institutions that can control the amount of money in an economy. By tinkering with monetary policy, central banks are able to speed up or slow down the economy. Examples of central banks are the Reserve Bank of Australia (RBA), European Central Bank (ECB), and U.S. Federal Reserve (the Fed).
- Domestic money supply is a term that refers to the amount of money circulating through an economy at a given point in time. When central banks use QE, the supply of money goes up.
A lot of people call quantitative easing “money printing.” This makes you imagine that the way central banks do QE is by cranking up the printing press to print endless sheets of $100 notes.
Well, that isn’t what happens. Instead, the way central banks actually do QE is by using newly created money (i.e. reserves) to buy financial assets from banks and other financial institutions. The result of this is an increased money supply and a reduced supply of the financial asset(s) that the central bank purchased.
What assets do central banks buy? The most common asset they buy are long-term government investment bonds. Some others are mortgage-backed securities and corporate bonds.
Once a central bank buys an instrument like a bond, its balance sheet grows. An example: Let’s say the RBA buys A$1,000,000 of bonds from a commercial bank. The effect of this is that the RBA’s balance sheet grows by $1,000,000. (Its accounts are still in balance because its assets and liabilities both rise by $1,000,000.)
Why Do Central Banks Do QE?
When central banks use QE, they’re trying to stimulate the economy. (Traditionally, they’ve done this by lowering interest rates. But because rates are already at historic lows, central banks are using more unconventional measures like QE.) Without policies like QE, there’s an argument that economic recessions would be more severe and longer.
QE is able to stimulate the economy because it boosts liquidity and promotes bank lending. In theory, QE induces more borrowing, spending, and investment. This helps keep people in jobs and get the unemployed a job. When this happens, wages go up and the economy grows at a stronger rate.
QE also makes people feel wealthier, which makes them more confident in the economy and willing to spend. (This is called the ‘wealth effect’.) QE promotes the wealth effect because it’s thought to inflate the prices of assets such as stocks and real estate.
Central banks turn to QE particularly when they are worried about deflation. (Deflation describes a reduction in the general price level of an economy’s goods and services.) That’s because deflation is a very bad situation for an economy to be in. It creates a downward spiral of falling prices that is notoriously difficult to reverse.
The Downsides of QE
Because QE puts downward pressure on interest rates and yields on interest-bearing securities, it can disincentivise saving in a big way. This is especially rough for those such as retirees and pensioners who rely on savings income.
It is also argued that QE makes income inequality worse. That is because companies are able to borrow cheaper money, which can be used for acquisitions and stock buybacks—both of these make stock prices rise. People with less money don’t own as many stocks as wealthier people. So when stock prices are increasing, the richer get disproportionately richer.
Another downside of QE is the not insignificant amount of risk that the policy is either more or less effective than intended. If more effective, QE could spur hyperinflation. QE can be less effective than expected if banks use the additional cash to increase their capital reserves to protect against a crisis.
Finally, QE puts downward pressure on the exchange rate of the economy’s local currency. For example, the RBA undertaking QE would weaken the value of the Australian dollar (AUD) compared to foreign currencies. In Australia, a weaker currency is particularly bad for businesses that rely on imported goods.
QE Is Not Helicopter Money
If you’ve ever heard of helicopter money, you might be thinking that this whole QE thing sounds pretty similar. Whilst both helicopter money and QE can expand the supply of money in an economy, the former is permanent and the latter is temporary. (Quantitative tightening (QT)—or QE tapering—is the reverse policy of QE, and is meant to come into effect once the economy starts growing strongly again.)
When a central bank uses helicopter money, it’s creating money and sending it to individuals and businesses in exchange for nothing. (This explains why you’ll often hear helicopter money being talked about as “quantitative easing for the people.”)
This is not the same as QE because helicopter money does nothing to a central bank’s balance sheet. Remember, under QE, central banks inject newly created cash into the economy by buying financial instruments like bonds from the private sector. The effect of this buying is an expansion of central bank balance sheets.