Quantitative Easing
What is Quantitative Easing?
Quantitative easing is a central bank policy of buying large amounts of long-term assets to inject money and lower interest rates when short-term rates are near zero.
It is used when conventional rate cuts are exhausted (rates already near zero). By buying bonds and other assets, the central bank raises their prices, lowers long-term yields, and expands the money supply to stimulate borrowing and spending.
Quantitative Easing: a worked example
A long term government bond with a face value of 500 dollars pays a fixed coupon of 15 dollars a year, a yield of 15 divided by 500, which is 3 percent. A central bank announces purchases of 600 billion dollars of such bonds, and the extra demand bids the price up to 600 dollars. The coupon is written into the bond and never changes, so the yield falls to 15 divided by 600, which is 2.5 percent. Now take a firm weighing a warehouse project expected to return 2.8 percent a year. At a 3 percent borrowing cost the project was rejected; at 2.5 percent it clears the bar, and on a 40 million dollar loan the annual interest bill drops by 0.005 x 40 million = 200,000 dollars. That flipped decision is the transmission channel.
The mistake students make with quantitative easing
Students hand this policy the wrong lever, writing that the central bank eases by cutting the rate it sets. Large scale purchases get used precisely because the short term policy rate has already reached its floor, so the action moves into the bond market instead. The exam version of the slip is drawing a rightward shift of money supply and reading a lower overnight rate off the money market graph. That diagram carries one interest rate, while this policy aims at the long end of the yield curve, so the graph cannot show the thing the policy is trying to move.
Quantitative Easing questions
How does quantitative easing lower long term interest rates?
Bond prices and yields move in opposite directions, so a buyer big enough to move the market lowers yields simply by bidding prices up. Purchases of long maturity assets also remove supply from private portfolios and push investors toward other long dated assets such as corporate bonds and mortgages, dragging those yields down as well. The announcement matters on its own too, because a promise of sustained buying changes what investors expect short rates to do later.
How is quantitative easing different from normal open market operations?
Scale and maturity separate them. A routine operation buys or sells modest amounts of short dated government bills purely to nudge the overnight interbank rate toward its target, and the balance sheet barely moves. Quantitative easing buys long maturity government bonds, and sometimes mortgage backed securities, in very large quantities, so the size and composition of the central bank balance sheet becomes the instrument rather than a byproduct. One fine tunes a single rate; the other tries to bend a whole yield curve.
Does quantitative easing always cause inflation?
Large asset purchases raise bank reserves, but reserves are not spending. Inflation follows only if banks lend those reserves out, borrowers actually use the loans, and total demand ends up above what the economy can produce. When households and firms are busy paying down debt, much of the new money sits in reserve accounts and prices respond weakly. The inflation risk grows when the economy is already near full employment or when the purchases are unwound too slowly.
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