Question

Discuss the following statements: Quantitative easing does not involve any interest rate channel on its transmission mechanisms.

Answer 1

Quantitative easing is a method whereby the central bank of a country buys the government issued securities and other securities. The purpose is to lower the interest rate and increase spending by creating a large flow of money into the economy. When the real interest rate falls to zero the quantitative easing is no longer effective. So the central bank targets a specified amount of asset purchase.

The quantitative easing directly impacts the asset prices. The asset price increase and the rate of interest falls. The increased asset price creates more purchase of such assets. This will increase the flow of money in the economy and reduce the rate of interest. The fall in interest rate reduce the cost of borrowing. Which stimulate spending with borrowed money.

The increase in asset price through wealth effect creates more consumer confidence and thereby increases spending. The fall in rate of interest increase the corporate spending. Both together constitute and increase in aggregate demand, price level, aggregate output and employment.

The quantitative easing increase the aggregate spending through the channel of decreasing the rate of interest. When the central bank purchases securities the cash reserve of the commercial bank increase which induce them to lend more at lower rate of interest. The increased flow of credit at lower interest rate creates more consumption demand and investment demand. Thus the quantitative easing works through the interest rate in its transmission mechanism.