An Explanation of Quantitative Easing: Intention behind US current Monetary Policy

By: Submissions

Sahil Hafeez writes: Quantitative easing (QE)
  
This is the Federal Reserve's (USA central bank) program of buying bonds from its member banks. The purpose of this expansionary monetary policy (A policy uses to stimulate economy) is to lower interest rates and spur (stimulate) economic growth.

How would FED implement QE?

The Fed purchases U.S. Treasury notes (the safest investments in the world backed by US government) and mortgage-backed securities (MBS, type of asset-backed security that is secured by a mortgage). It issues credit (giving money) to the banks' reserves (banks' holdings of deposits in accounts with their central bank) to buy the bonds (debt security).

Where does the money come from to purchase these assets?

The Fed has the ability to simply create it. This unique ability is a function of all central banks (State Bank). It has the same effect as printing money (introduce new money into the economy).

How does quantitative easing work?

The Fed adds credit to the banks' reserve accounts in exchange for MBS and Treasuries. The reserve account is the amount that banks must have on hand each night when they close their books. The Fed requires that around 10% of bank deposits be held either in cash in the banks' vaults or at the local Federal Reserve Bank.

What would happen if FED adds credit?

When the Fed adds credit, the banks have more than they need in reserves. They now have more to lend to other banks. As banks try to unload their extra reserves, they drop the interest rate they charge. This is known as the Fed funds rate. This rate is the basis for all other interest rates.

What are the reasons behind QE (Quantitative easing)?

QE increases the money supply because lower interest rates allow banks to make more loans.  Bank loans stimulate demand by giving businesses more money to expand, and shoppers more credit to buy things with.

Why there is the need of increasing money supply?

By increasing the money supply, QE keeps the value of the dollar low. This made U.S. stocks seem like a relatively good investment to foreign investors, and made U.S. exports relatively cheaper.

What would be ultimate results of QE?

Quantitative easing stimulates the economy in another way. The Federal government auctions off (sell at an auction) large quantities of Treasuries to pay for expansionary fiscal policy (the use of government revenue collection (taxation) and expenditure (spending) to influence the economy). As the Fed buys Treasuries, it increases demand, keeping Treasury yields

low. Since Treasuries are the basis for all long-term interest rates, it also keeps auto, furniture and other consumer debt rates affordable. The same is true for corporate bonds, allowing businesses to expand more cheaply. Most important, QE keeps long-term, fixed-interest mortgage rates low. And that's important to support the housing market.

Why Quantitative Easing is bad?

Each time you add a new dollar to the system, it decreases the value of each existing dollar by just a little bit. Inflation is going to hit high.

By Sahil Hafeez

Qualifications: MBA, CFA, FRM
Current City: Hong Kong

© 2013 Copyright  Sahil Hafeez - All Rights Reserved

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