Quantitative easing is the process the central bank of any country undertakes to stimulate economic growth after other traditional processes have failed. According to the House of Commons Treasury Committee (p. 21), when undertaking quantitative easing the central bank supply more money to the banking system to maintain the interest rates at zero or reduce it to lower rates. The central bank achieves this mainly by buying assets from banks.
The Bank of England (p. 1) notes that quantitative easing is the process of putting more money back into the economy to encourage spending. For a country to experience positive growth, inflation has to be constant. To regulate inflation the central banks use interest rates. The financial institutions borrow money from the central bank using these set interest rates. The movement of the interest rates can affect other rates available in the economy. For instance, it is used to regulate the money supply thereby affecting the spending of the companies and the consumers. Additionally, it affects the rate of inflation in the long run.
To maintain inflation at a constant rate, the central bank alters the current interest rates. However, there are cases where the central bank is concerned about the risks of low inflation. As a result, the central bank reduces the interest rates. The central bank has to ensure that the interest rates do not fall below zero. If the bank rates are almost zero and there are indications that they might fall below the current figure, the bank increases the amount of money in supply.
The concept of quantitative easing is based on the fact that there are some risks associated with too little money in circulation. Since too much money in circulation leads to higher inflation and too little money in circulation leads to slow economic growth, the central bank needs to maintain a constant rate of inflation. Additionally, the Bank of England (p. 7) suggested that the money in supply needs to continue increasing at a constant rate for any country to realize positive growth in the economy. Quantitative easing also ensures that the government can maintain constant inflation.
During the process of quantitative easing, the central bank does not print more money but buys assets from privately owned financial institutions. The central bank, therefore, increases the reserves of the selling bank. As a result, there is more money in supply than before the process was initiated. The increase in the money supply by any central bank may have several effects on the economy. First, the seller of the assets to the central bank may opt to spend it. This might stimulate positive growth of the economy. Secondly, the sellers might use the money to purchase other assets. Those people who own such assets benefit from the buyers and gain money that they too can spend (House of Commons Treasury Committee p. 23).
An increase in money supply leads to an increase in the prices of assets. As a result earnings from assets are reduced and this leads to a reduction of the costs of borrowing for both businesses and personal uses. Lastly, as a result of the increase of the commercial bank’s reserves with the central bank, the banks start to lend to their customers and businesses. However, commercial banks may opt to hold on to the reserves rather than encourage borrowing. For this reason, many central banks avoid buying assets solely from commercial banks.
The Federal Reserve System is the central bank of the United States. On several occasions, it uses its powers to control the interest rates by purchasing financial assets. An example of one of these instances is during the 2010 financial year. According to Feldstein (par. 1), the American economy had experienced positive growth in 2010. Much of this development was a result of the policies implemented by the Federal Reserve (Fed). The main factor that led to this positive development was an increase in consumer spending (par. 4). During that year consumer spending grew by 4.4%. The rise in consumer spending was not in any way attributed to higher employment or economic growth of the people. It was attributed to a fall in savings which had increased consumer spending.
Another indicator to show that quantitative easing had worked is the stock market. The stock market increased constantly from August to the end of the year. The increase in the stock market encouraged consumer spending and also discouraged savings. The Fed stimulated the sharp increase in the stock market by participating in buying Treasury Bonds. Feldstein (par. 7) noted that the Fed was considering initiating another quantitative easing which would be called QE2. Under this new phase, the Fed hoped to buy long term treasury bonds. As a result of this new phase, it was expected that the prices of bonds would rise and the bondholders would be more willing to trade their bonds and spend the money in the economy instead of saving.
Feldstein (par. 11) expresses concerns about the United States growth for the year 2011. He noted that it could have been hard for the country to grow given that the Fed was withdrawing its massive buying of treasury bonds. This shows that the Obama administration used the quantitative easing method to successfully stimulate the country’s growth for the year 2010. The country achieved this by encouraging consumer spending through the purchase of treasury bonds.
However, though the positive growth was experienced at a time when the Obama administration was in office the process had been started in the year 2007, when the Fed noticed that Wall Street was falling. This was during President’s Bush Administration. According to the New York Times (par. 4), the central bank had held the interest rates at almost zero since December 2008. In addition, it had also accumulated more than $2 trillion in debt in a bid to lower long-term interest rates. The central bank provided emergency loans to banks. It also purchased banks’ assets all totalling about $7.8 trillion in 2009. These events helped to prevent a financial crisis (The New York Times par. 6). These events also attracted investors to the market.
In conclusion, the financial crisis of 2008 made the Fed drastically introduce the quantitative easing process to prevent negative economic growth. This happened during the end of the Bush administration and at the beginning of the Obama administration. Therefore, during both administrations, quantitative easing was experienced. Most of the effects of quantitative easing are felt in the long run. Therefore, the economic development experienced at the end of 2010 was a result of the quantitative measures taken by Federal reserves (Sidlow and Henschen p. 41).
Works Cited
- Bank of England. Quantitative Easing Explained. 2011.
- Feldstein, Martin. Quantitative Easing and America’s Economic Rebound. 2011. Web.
- House of Commons Treasury Committee. Pre-budget Report 2008.
- United Kingdom: The Stationery Office, 2009. Print.
- Sidlow, Edward and Henschen, Beth. Govt. 2010. USA: Cengage Learning. Print.
- The New York Times. Federal Reserve (The Fed). 2012.