Question

Quantitative Easing (QE) is an alternative monetary policy which aims at increasing money supply when traditional instruments such as lowering interest rates fail. Explain how QE works and how does it infuse new money in circulation . Critically evaluate its benefits and drawbacks.

Answer 1

QE works through the framework where central bank buys government securities, and in turn increases money supply by flooding financial institutions. This is done to give a boost to lending by banks and improve economic activity and growth.

Say, when interest rates in US were almost nearing zero, after recession, this indicates a situation where there is no visible growth in the economy. To prevent this, Federal bank intervened by announcing QE measures, where it promised to buy Government bonds in turn infuse money into the economy through financial institutions. Lending is promoted, with an expectation that it gives a boost to economic activity and growth.

By year 2012-13, once economy has shown signs of recovery and positive growth, Federal bank announced tapered QE, meaning that the amount of money it promised to infuse into economy will decrease gradually in a tapered fashion.

Positives:

One of the benefits of QE is that, it potentially reverses downward trend of an economy and can give a strong boost to economic activity. This is important as sentiment is altered into growth side, which assures investors and businesses confidence in the economy.

Drawbacks:

Can also lead to undesired inflation, if the infusion of money doesn’t promote economic growth activity. in such cases, if economic activity doesn’t pick up, there will be more money in economy after QE. Thus more money chasing same number of goods, a perfect direction towards inflation.