Quantitative Easing (QE)

Also known as QE, quantitative easing involves the large scale purchase of assets by a central bank. These purchases involve both mortgage-backed securities as well as government bonds (Treasury securities). A central bank will use this approach when it wants to stimulate an economy.

A more conventional approach involves the buying or selling of short-term government bonds to keep interest rates within a target range. Unfortunately, when short-term interest rates approach zero, this tactic is no longer effective. By purchasing assets that are riskier, such as mortgage-backed securities, the central bank is able to lower longer-term interest rates too.

Quantitative easing is considered an unconventional monetary policy and is typically deployed when conventional policies have failed to reverse inflation. By engaging in the large scale purchase of mortgage-backed securities, the money supply increases and longer-term interest rates will fall. Corporations will take advantage of lower interest rates and borrow additional capital to fuel their growth. The increase in spending creates both indirect and direct jobs. This reduction in unemployment increases consumer spending, thereby further stimulating the economy.

The risk of this approach includes over-stimulating the economy, which can lead to inflation. The strategy can also falter if commercial banks fail to lend these additional funds to businesses. Finally, quantitative easing can trigger a devaluation of local currency resulting in higher prices for consumers when purchasing imported goods.

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