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What is Quantitative Easing?

December 6, 2010

It seems that some people are understandably unfamiliar with exactly what Quantitative Easing is. So I decided to create a little info-graphic and explain how it works.

Quantitative Easing is when the U.S. Federal Reserve purchases government bonds (loans to the government which pay interest to the holders of said loans) in the open market where bonds are traded. This purchase decreases the amount of bonds in circulation and makes them scarcer. When there are less government bonds in circulation, they cost more to purchase; this decreases the return the bond holder gets from them when they come due (the principal + interest).

The goal of this purchase is to effect the interest rates financial institutions charge.

The idea behind purchasing government bonds is the rate of interest on federal bonds is related to other interest rates on things like loans to businesses. If government loans only return a very low interest rate to the loan holder, then they will invest in other types of loans which have a higher interest rate. Also, as the loans are purchased with cash, the seller of the bond (often banks) now has cash which gives no interest and will seek to invest it. This increases demand for other types of loans, and hopefully leads to lower interest rates being charged as well as an increase in supply. Whether or not this process works depends on how sticky prices are, because the central bank will be printing new money to purchase the bonds.

Quantitative easing is generally used when other mechanisms for adjusting interest rates, such as changing reserve requirements and lowering the federal funds rate, have not worked.


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