In this video we’ll look at the concept of quantitative easing and understand why
a central bank would pursue QE.
Ultimately we’ll seek out the impact on the country’s money supply if QE is successful.
First, let’s discuss what Quantitative easing, or QE, is exactly.
Quantitative easing, or QE, occurs when the central bank purchases financial assets such
as government bonds and corporate bonds from the private sector in an attempt to increase
the money supply and lower the rate of interest.
That’s the basic definition, but lets dig a little deeper.
The question we need to answer is why a central bank would pursue this and also try to understand
specifically how QE works.
Quantitative easing measures are used when traditional monetary policy has failed.
There are a few reasons for this.
In a low or zero interest rate environment, it is very difficult to lower interest rates
any further.
Individuals are likely to prefer holding cash rather than put their money in low return
financial assets – this is known as the liquidity trap.
To get the economy moving, the central bank can use QE to inject liquidity into the economy.
If banks are reluctant to lend in times of economic uncertainty, the central bank can
intervene and use QE as an emergency response to a crisis such as the credit crisis in 2008
and COVID-19 in 2020.
Again, the objective is to inject liquidity into the economic system.
I’ve said that the aim is to inject liquidity into the economic system, but what do I mean
by that?
Let’s look at how QE works.
Quantitative easing includes the purchases of government bonds, corporate bonds and other
financial assets from commercial banks and other financial institutions.
This provides liquidity for these institutions.
The focus of QE is not strictly commercial banks, but other financial institutions such
as insurance companies, pension funds, hedge funds and investment banks.
Since QE increases the demand for bonds, it will reduce their yields.
Bonds are typically considered safe investments for investors, so when the yield decreases
– so does their attractiveness to investors.
Remember, it’s not just banks and individuals that hold bonds, but the other financial institutions
listed before as well.
If the central bank purchases these bonds, these institutions will find themselves with
more cash than before.
With bonds being less attractive, they will look to invest their money elsewhere.
But why did bonds become less attractive and how did the yields decrease?
Let’s see how with an example.
Suppose the government issues a 10-year bond with a face value of $10,000.
It pays out a coupon of $500 per year and thus has a 5% yield.
The yield is calculated as such: $500/$10,000 x 100%.
If the central bank starts QE and increases the demand for 10-year bonds, then they could
drive up prices of these bonds to $11,000.
The coupon will stay the same at $500 but the yield has changed.
The yield is now $500/$11,000 x 100% = 4.54%.
As such, the bond has now become a less attractive investment.
With all this activity, what’s the ultimate result on the money supply?
An effective strategy of QE will increase the money supply.
Commercial banks have more reserves to lend out.
Investors move funds out of bonds into assets that can provide greater rewards such as stocks.
Investment into stocks can increase their prices, creating a wealth effect.
The market can view QE as a sign that the government is taking action, which in turn
boosts business confidence.
The overall effect will be to increase the money supply, increase lending and increase
business and consumer confidence.
Effective QE helps boost the performance of the economy and limits the extent of an economic
downturn.
By now you should be able to explain what QE is, why central banks would pursue it and
how it impacts the supply of money in an economy.
If you have any questions, leave them below and let’s try and answer them together.
That’s us done for now and I will see you in the next one!