Monetary policy of a country is defined as discretionary action undertaken by the authorities designed (example-the Federal Reserve in USA or RBI in India) to influence
- The supply of money
- Cost of money or Rate of interest
- The availability of money.
The above stated factors are influenced with an aim to achieve price stability, high employment and faster rate of economic growth for the country.
There are 2 types of Monetary Policy:
- Expansion monetary policy- is when the central bank attempts to stimulate the economy by lowering interest rates and increasing the money supply.
- Contraction monetary policy- is when the central bank attempts to cool the economy by increasing interest rates and lowering the money supply.
As mentioned above, a standard monetary policy is used to achieve lower interest rates to stimulate investment & consumption which generates economic growth. However, this monetary policy has its limits.
When the interest rates are zero or near zero percent and the economy is still struggling? What does a central banker do? Well, in such scenario, where the standard monetary policy becomes ineffective, central banks may consider Quantitative Easing.
What is Quantitative Easing?
When economy of USA was struggling, as was the case around the world in the wake of the 2008 crash, governments often look for ways in which they can pump in money in order to keep the economy from stagnating.
Quantitative easing happens when a central bank buys government bonds or other financial assets in order to inject money directly into the economy. These financial assets are pre-decided by the government and are bought from commercial banks and other financial institutions, as a result of which the prices of these financial assets increases and their yield decreases. With lower interest rates bank can now lend easily and much cheaper rate thus increasing the money supply in the economy. The idea is that these institutions will in turn be more willing to lend out money at lower rates, thereby helping the central bank/government achieve and maintain low interest rates.
It’s an unconventional form of Monetary Policy, which is used when inflation is very low or negative. When both the investors and consumers have lost their faith on the economy and no-one is investing money in development projects. Quantitative easing (QE) is also known as large-scale asset purchases. Where government purchases bonds thus infusing money in the economy, so that new development projects can be started, new jobs can be created and economy can grow.
Risks of Quantitative Easing
- Inflation: While the supply of money increases, the supply of goods remains the same, thus prices rise. Can also give rise to period called “Stagflation”.
- International Trade: As more money gets circulated in the economy, the value of domestic currency falls, as a result of which the imports become expensive.
- Credit ability: reflects the inability of the country to generate real growth and to honor debt.
- Effects on markets after QE: its often observed that the stock market falls when it is announced or speculated that the quantitative easing program will be brought to an end.
- Increase in Debt: QE encourages additional borrowing by both consumers and businesses. Bad loans can further exacerbate an already fragile economy.
Effectiveness of the Quantitative program
During the QE programs conducted by the USA Federal Reserve starting in 2008, the Fed increased the money supply by $4 trillion. However, banks held onto much of that money as excess reserves. At its peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome for the Fed’s QE program.
Following the Asian Financial Crisis of 1997, Japan fell into an economic recession. Beginning in 2000, the Bank of Japan (BoJ) began an aggressive QE program to curb deflation and to stimulate the economy. The Bank of Japan moved from buying Japanese government bonds to buying private debt and stocks. The QE campaign failed to meet its goals. Ironically, the BoJ governors had concluded that “QE was not effective” just month before launching their program in 2000. Between 1995 and 2007, Japanese GDP fell from $5.45 trillion to $4.52 trillion in nominal terms, despite the BoJ’s efforts.
The Swiss National Bank (SNB) employed a QE strategy following the 2008 financial crisis. Eventually, the SNB owned assets nearly equal to annual economic output for the entire country, which made the SNB’s version of QE the largest in the world as a ratio to GDP. Although economic growth has been positive during the subsequent recovery, how much the SNB’s QE program contributed to that recovery is uncertain.
There will always be risk associated with the Quantitative Easing program, so it is important that the money that is printed is distributed and filtered into the economy in a controlled way.