What is QE – Quantitative Easing

What is QE?

Quantitative easing, better known as QE, is a monetary tool used by central banks to stimulate the economy. It aims to stimulate the economy by injecting money into the economy through the purchase of financial assets and government bonds from banks. In this way, with excess money, they can motivate credit applications, stimulate production, stimulate consumption and maximize employment.

How does QE work?

Whenever an economy is in a fragile state Central Banks will try to reverse the trend by influencing the currency to boost spending and lending.

To do this they have a few tools at their disposal. Before resorting to QE the alternative is to adjust the central interest rate. When a central bank lowers its interest rate, then other interest rates, such as the rate on a home loan or personal loan, will fall as a consequence. In theory, a low cost of borrowing will encourage consumption. The associated risk is that it is easy for these interest rates to go into the negative range and not have the desired result, so QE is necessary.

QE is considered a more aggressive monetary stimulus, so it is used after other possibilities have been exhausted. It is normally used in periods of economic crisis when banks will be less willing to lend to companies or individuals due to the uncertainty caused.

We can show how QE influences the economy by dividing its consequences into steps:

  1. Central Banks buy financial assets from national banks. This transaction transfers financial assets to the Central Banks and the money into the coffers of the national banks, thus creating liquidity.
  2. This money, now injected into the economy, allows national banks to lend more. This great availability creates more supply and a lowering of interest rates allowing for cheaper loans.
  3. With these cheaper loans there is a greater tendency to invest, be it in buying a house, creating or improving a business, or even investing in the financial markets. This incentive to invest helps to increase confidence in the growth of the economy because it increases the circulation of money, creating jobs that culminate in an environment of economic stimulus and prosperity.

Possible disadvantages of QE

Inflation is the biggest danger of using QE in the economy because it has a direct influence on the increase of money in circulation.

As is well known, the increase of money in circulation leads to the devaluation of the currency, increased production costs and prices of final products, and consequently, any imports will become more expensive. If not properly controlled by the respective Central Banks, this can lead to an uncontrolled rise in the inflation rate.

Another possible danger is the emergence of asset bubbles. With more money to invest, the price of products such as stocks or real estate tends to rise as long as the injection of money is maintained.

As soon as these stimuli are reduced or eliminated from the economy and investors suddenly begin to withdraw their investments from the markets causing sudden price drops, because they tend to react together.

Conclusion

QE is undoubtedly a powerful tool in the hands of Central Banks, however, it is a rather difficult one to control. Although it aids economic recovery, it can also create problems such as inflation or the emergence of asset bubbles, which are hardly controlled without generating negative economic consequences.

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