What is Quantitative Easing?

Quantitative easing is an economic term describing an action that may be taken by a country's central bank in times of economic stress. A central bank controls the amount of available currency in a country, and it can create new money through what are known as open market operations. Put very simply, this means that the central bank creates or prints money out of thin air, although in an indirect way. When this is done in order to stimulate an economy in recession, it is known as quantitative easing, since it seeks to ease an economic burden by increasing the quantity of available currency.

Most of the world's central banks have engaged in this practice at one time or another, including the United States Federal Reserve, also known as the Fed. One of the most common methods of quantitative easing that is employed in the U.S. is when the Federal Reserve buys the federal government's Treasury bonds. It can also be done by lending new money to distressed banks, or buying a bank's assets for the new currency, or by any combination of the three methods, which are known as open market operations.

Any of the three techniques have a specific and predictable outcome, namely the lowering of interest rates. In the case of buying government bonds, the yields on these instruments decrease. If money is loaned to banks or given in exchange for assets, the rates that banks charge one another for short-term loans are decreased, thereby encouraging banks to loan money, and to increase the supply of money in the economy by doing so. When we hear it reported that a central bank like the Fed has changed its target interest rate, this actually means that it changes the way it conducts open market operations.

In response to the economic slump which began in late 2008, the Federal Reserve began using quantitative easing to address the situation. The goal of such actions was to jump-start a troubled banking system, without which the economy would be in even deeper trouble. Quantitative easing is ideally reserved for emergency situations, because of the risk it involves, namely that of inflation.

Inflation has been defined as too many dollars chasing too few goods. The easy availability of cheap money often translates down the road into higher prices for consumers, as well as the loss of the value of personal savings. Reckless central bank policies in some countries have led to hyperinflation, which is simply a very high rate of inflation, so high that the value of a currency may change significantly over the course of a single day. Hyperinflation can quickly bring an economy to a halt, while making the affected currency worthless in the process.