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What Is Quantitative Easing Explained – Definition, Risks & Effects on the Economy

By Kalen Smith

us dollar healthWhen an economy is in danger of slipping into a recession or depression, governments can employ a strategy known as quantitative easing (QE).

Quantitative easing is a monetary policy instituted by central banks in an effort to stimulate the local economy. By flooding the economy with a greater money supply, governments hope to maintain artificially low interest rates while providing consumers with extra money to spend more freely, which can sometimes lead to inflation.

What Is Quantitative Easing?

The Federal Reserve prints money to finance the purchase of government treasuries from financial institutions in an effort to pour extra money into the economy. The idea is that these institutions will in turn be more willing to lend out money at lower rates, thereby helping the central bank achieve and maintain low interest rates.

In addition, quantitative easing can fuel economic growth since money funneled into the economy should allow people to more comfortably make purchases. This can have a trickle down effect on both the consumer and business communities, leading to increased stock market performance and GDP growth.

The important thing to remember is that quantitative easing generally leads to short-term benefits with the risk of exacerbating long-term problems. As a result, it is often used as a last resort when the economy faces a great risk of a recession or depression.

Reasons the Fed Uses Quantitative Easing

The Federal Reserve uses quantitative easing for a variety of reasons:

  1. Foster maximum employment. The Fed argues that money printed through the QE program can be used to help create new jobs for Americans since businesses should end up with more cash on hand to finance new hirings. However, critics argue that any actual employment benefits are only temporary.
  2. Encourage lending. The general premise behind this claim is that central banks can reduce long-term interest rates by buying treasuries. In providing financial institutions with more cash, these institutions should be more willing to lend out money at lower rates. Such loans then act to further stimulate the economy through higher consumer spending and business development.
  3. Encourage borrowing. Low interest rates tend to encourage increased borrowing. Although this can help stimulate the economy, some argue it also has the tendency to encourage customers and businesses to take on unnecessary debt. At the same time, some level of debt and leverage is essential to the growth of any economy, especially one in dire straits.
  4. Increase spending. The theory is that as more money enters the economy, consumers will have more to spend. This will in turn increase company profits and create more jobs, helping stimulate the stock market. Ultimately, these factors should result in newfound consumer confidence and an economic recovery.
  5. Complement low interest rates. Another tool used to stimulate the economy is the federal funds rate. By setting this rate low, the Fed can effectively encourage lending. But what if this rate is already low, and yet the economy continues to struggle? Consider the case in the late 2000s when the federal funds rate was set between 0% and 0.25%. The central bank could not lower the rate any further. As a result, quantitative easing gave the Fed another monetary tool to stimulate the economy through an increased money supply.

Many of the arguments for quantitative easing make sense theoretically. However, some economists criticize these claims and feel that quantitative easing only provides short-term benefits. Some of these debates are also politically motivated.

There is no doubt that quantitative easing provides some benefit to a struggling economy. Yet, how much benefit it provides to the current state of the US economy remains to be seen.

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Risks of Quantitative Easing

Quantitative easing has come under fire for multiple reasons:

  1. It drives inflation much higher. This is the biggest concern around quantitative easing. As more money circulates through the economy, prices rise. Why? While the supply of money increases, the supply of goods remains the same. Thus, the competition for each good increases, leading to increased prices, which in turn leads to inflation. Excessive inflation leads to distortion of prices and incomes, and can cause an economy to operate inefficiently.
  2. It creates havoc with international trade. Newly printed money can be used by the government and consumers to import new goods and services from other countries. These goods and services are more or less coming in for free. Sounds like a great deal, right? The problem is that sooner or later other countries end up getting sick of exchanging goods and services for what they feel are worthless sheets of paper. In other words, the value of the importer’s currency decreases, which can discourage exporters. For example, China stopped exporting valuable minerals to the U.S. due to its quantitative easing program.
  3. Threat to the U.S. dollar. Many countries get frustrated with attempts at currency manipulation like quantitative easing. They feel that these practices reflect an inability by the country to generate real growth and to honor debts. For example, other countries have become weary of lending the U.S. more money. Also, the status of the U.S. dollar as the world reserve currency is in jeopardy, likely because of quantitative easing.
  4. Benefits don’t outlast QE programs. When the central bank stops printing money, the recovery often gets put on hold, or worse, begins to reverse. Although the hope is that new consumer confidence will inspire a real recovery, many feel these programs are only a short-term fix. This effect is exhibited by the fact that stock markets often fall when it is announced or speculated that the quantitative easing program will be brought to an end.
  5. Encourages debt. Another key worry about quantitative easing is that the increased money supply and low interest rates encourage additional borrowing by both consumers and businesses. While some debt can help stimulate an economy, wanton loans and excessive debt can further exacerbate an already fragile one. Moreover, quantitative easing can lead to an increased government deficit as was the case with the U.S. in 2010 when it actually reached its debt ceiling.

While quantitative easing programs can fuel the economy, they can also dig a country into a deeper hole. The key to a successful QE program is to strategically implement it just long enough to promote real and lasting improvement. Unfortunately, the ability to do so is much easier said than done.

Future of Quantitative Easing in the U.S.

The U.S. is currently going through QE2, which is actually the third time we have used quantitative easing. This program is structured to end this year and it is unclear if the Fed will initiate another round or not.

What if QE ends?

When the stock market was crashing in 2009, the Fed used QE1 to help prevent the stock market from causing a panic. If the market had been allowed to fall too much, the U.S. likely would have found itself in a deep depression. The end of quantitative easing now will probably not bring the U.S. back to the lows of 2009, but most experts are sure the market and the economy will take a major hit.

Also, interest rates will likely increase significantly. As a result, borrowing and lending will be severely restricted, which could drastically limit economic growth and even lead to a mild recession.

What if a new round of QE is launched?

Continuing QE can be just as problematic as ending the program. In the short term, it could lead to a boost in the economy as consumers celebrate the increased money supply and low interest rates. But over time, successive rounds of QE will cause the value of the dollar to deteriorate further and potentially lose its status as the world reserve currency. The price of food, gas, and other goods could increase if inflation continues, which would make it very difficult for consumers to afford their everyday needs.

Should QE go on?

While ending QE can lead to a deflationary depression if markets don’t naturally correct themselves, continuing QE can lead to an inflationary depression. Both of these situations can be disastrous, so economists are torn regarding which direction the U.S. should pursue.

Final Word

Quantitative easing is a controversial topic for economists and politicians alike. Some feel it can save a struggling economy, while others feel it can destroy one. Since the consequences of continuing a QE program are so serious, it is generally reserved for situations when a country feels it has no other options.

Did the U.S. employ it too soon? Are there no other alternatives? It is hard to say what the right answer is, but more and more economists are speaking out against quantitative easing as they witness the consequences it holds for a nation’s economic well-being.

What are your thoughts on quantitative easing? Should the U.S. continue to use it as a way to control and spur on the economy?

(photo credit: Shutterstock)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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