Question

Explain why quantitative easing to stabilize the US economy was considered a moral hazard (i.e., why will QE paid in 2008 will cause future banks to behave badly

Answer 1

Quantitative easing refers to a monetary policy wherein the Fed purchases the government bonds or other financial assets with a goal to inject money into the economy for the expansion of the economic activities. The policy of quantitative easing brings causes a decline in the rates of interest in the short run. But in the long run it causes inflation which results to a rise in the interest rates therefore resulting to the exact opposite of financial stability; and creates moral hazard for governments.

The central bank during the 2008 crisis was forced to alter the traditional approach. Since the rate of interest had approached zero, thus it launched quantitative easing programs with a motive to increase supply of money with a direct rise in monetary base rather impacting the price of bank reserves. There was a risk as the reduced fed funds rate may cause hyperinflation in the near future. Fed acts as bond buyer of last resort and is prepared to buy the government securities without limit. The market discipline will be incapacitated in these circumstances and cause future banks to behave badly.