Question

What is quantitative easing? Provide an example?   What is the Fed’s current approach on this topic?

Answer 1

Quantitative easing: Federal Reserve Bank can go ahead and create the new currencies either electronically or by printing new currencies. New supply of money can be flown by purchase or buy back of existing government and treasury securities. This activity is broadly classified as quantitative easing. This method directly or indirectly increases the supply of currency in the market and helps improving the purchasing power of the individuals and ultimately results in inflation. Federal reserve bank also does it differently, by decreasing its interest rates which would improve the supply of money at lower rate so that more participants remain interested in borrowing and lending. Federal reserve can target the inflation number and accordingly increase the supply of money in tune to targeted inflation.

Example: Best example can be have seen in financial crisis 2008-2014. The fed balance sheet almost doubled because of quantitative measure. In 2008 the liquidity was very low and to address that fed have taken the Quantitative easing approach. If Federal reserve bank keep supplying new money market then people can buy and lend for lower rates. Once they will start lending and borrowing at lower rates the liquidity will improve. Federal Reserve Bank (Fed) can reduce the interest rates at which financial institutions borrow from the Fed. How this will impact? As interest rates are reduced the banks or financial institutions will be able to borrow at lower cost from Fed. Suppose, $ 1 Billion was earlier borrowed at 1% p.a which was equivalent to $ 10 million interest cost after reduction in interest rate same $ 1 Billion can be borrowed at 0.75% p.a hence, the cost of borrowing will become $ 7.5 million. Now, banks can go ahead and lend at lower cost to their clients. As client or borrower can borrow at lower cost they can spend more money at lesser cost. The flow of money will increase purchasing power of individuals. Purchasing power will chase the limited supply of goods and prices of goods would rise hence, inflation number will also rise.

Presently, Federal Reserve Bank is increasing its interest rates, which means it is sucking liquidity in the market and it is reserve of quantitative easing. Here fed wants to decrease the liquidity in market and reduce the inflation.