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How Does Quantitative Easing Work?

There has been a lot of talk the last week about quantitative easing and more specifically, Quantitative Easing 2 or QE2. But how does the QE process really work? I hope to answer that question in language that makes sense.

One of the government’s responsibilities is to keep the economy stable and there are a number of methods that it uses to try to do this. One of the most common methods is adjusting interest rates.

When the economy is going well and inflation is growing too fast, the government can raise interest rates. But who do they raise the rates on? The banks. When the government raises the interest rates that it charges the bank, the bank in turn must raise the interest rate that it charges the consumer (be it an individual or a business). With higher interest rates leading to higher borrowing costs, less individuals and businesses borrow money, which causes consumption to slow down, thereby slowing the overall growth of the economy.

On the other hand, when the economy is growing too slowly, the government can lower interest rates. This in turn will decrease borrowing costs and allow more individuals and businesses to borrow money. When individuals can borrow more money at low interest rates, they make purchases such as homes or cars or anything that can be bought with credit, which leads to economic growth. When a business can borrow money at low rates, it expands by adding new locations, developing more products, increasing advertising, etc. It then needs to hire more people, which means more individuals will have the money they need to purchase goods and services. Thus, the economy grows, all because interest rates were lowered.

But what happens when interest rates get so low that the government can’t lower them any further? What happens if rates get to almost zero as they have recently? That’s when the government has to turn to one of its other methods to help the economy grow.

Enter “quantitative easing”—aka the creation of money.

As a side note, notice that I did not say the printing of money. Even though this phrase is throw around, the government is not actually printing money. What they are doing, however, is simply crediting the banks with a monetary figure. Therefore, if they buy $5B worth of treasuries from the banks, they don’t actually print $5B dollars. They simply give the bank a credit of $5B dollars. Ultimately, it has the same impact since the banking system now has money on its balance sheet that didn’t exist before.

Unlike interest rate adjustments, that either encourage or discourage individuals and businesses from spending money, quantitative easing uses the force of supply and demand to encourage spending. When the government buys its own securities from the bank, it infuses cash into the banking system, which increases the supply of cash. If the banks have a lot of cash, they will (supposedly) lower the interest rates they charge to consumers and businesses, which will encourage these entities to borrow more money and expand, which in turn helps the economy as described earlier.

On the other hand, since the government is buying its own securities, the supply of these securities decreases, which means the demand increases and causes their value to increase. Remember that the value of these securities (government bonds) moves inversely to interest rates. Therefore, when banks lower their interest rates because of the newly-found cash the government gave them to lend, the value of government bonds will increase. For a more detailed discussion as to why the value of bonds fluctuates inversely to interest rates, see my 10/8/09 blog article titled What Do You Mean My Bond Lost Value?”.

In conclusion, there is one other effect that quantitative easing will have in the future: increased inflation. Inflation is simply another way of saying that a dollar won’t buy as much in the future as it does now because it will be worth less (not “worthless”—although that is debatable). We go back to the supply and demand approach. When the government creates money, the supply side of the equation increases, which in turn lowers the value of the dollar.

Just as the government is having a difficult time stimulating the economy now, it will have as hard of a time, if not more, controlling inflation later. Although it will likely be some time before this happens, it will happen, and when it does, the cost of living will skyrocket. 

Fortunately, there are conservative investments that are designed to keep pace with inflation.  If you would like to learn more about these options, please contact us to schedule a Free Financial Physical.

 

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