THE US seems ready for another round of quantitative easing to boost growth, employment generation and consumer spending. There is consensus among economists and policymakers in the world's largest economy that the Federal Reserve should target a higher level of inflation to spur growth. ET takes a look at the concept of quantitative easing.
What is quantitative easing?
Central banks usually stimulate a slowing economy by cutting interest rates, which encourage people to spend by borrowing more and discouraging them to save. But with interest rates in the developed world already close to zero, that option is no longer available. In such situations, the central banks resort to pumping money directly into the economy, a process known as quantitative easing. It is done by buying bonds — usually government paper but can also be private bonds — from banks and financial institutions. The developed countries used quantitative easing to spur growth in the aftermath of the financial meltdown of 2008.
What is the idea behind quantitative easing?
At any given point of time, there is a fixed amount currency/money chasing products and services available in the economy. The idea essentially is to get more money into the system chasing the same amount of produce to drive up their prices. In the case of quantitative easing, the bondsellers will receive money that has not been in circulation, which will increase the money supply in the system. As the money in the economy increases, the demand for different products rises.
How does it help?
The flood of cheap money causes asset prices to rise — the prices of shares, real estate and similar assets. The notional high wealth, together with cheap and easy credit, encourages people to spend. Quantitative easing also helps devalue the currency thereby encouraging exports further increasing the level of activity in the economy. The final consequence is increased demand resulting in ramping up of production, which in turn creates more jobs in the economy.
Why is it important in the current scenario?
Quantitative easing could potentially ward off deflationary expectations and kickstart an uncertain economy. But in today's globalised world, cheap money from developed economies may flow into emerging economies and fuel asset bubbles and inflation there. Brazil is struggling to deal with the rising tide of inflows. India too is keeping and eye on increasing forex inflows.
