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Quantitative easing is a term used to describe a central bank's efforts to encourage lending through lower interest rates. It accomplishes this goal by purchasing government and other securities in an effort to increase the money supply and lower interest rates.
The theory is that by providing banks and other financial institutions with capital, they will feel more confident about lending money.
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How Does Quantitative Easing Help the Economy?
Short-term quantitative easing is generally beneficial when it comes to helping reboot or kick start a stalled economy. Essentially, the process creates new money or the economy. That's why many opponents of QE refer to it as "printing money." The key is to keep it short-term and to taper the "easing" as quickly as possible.
The benefits of quantitative easing include increased lending by banks. This means that more people are able to buy homes, cars, and other items that banks were reluctant to lend money for in the height of the recession.
The "trickle down" benefit of QE is that when people start making more purchases, jobs are created. We live in an "on demand" marketplace. When demand is up, production is up, more workers work more hours and bring home more money to drive the economy even further in the right direction.
It was never intended to be a long-term solution. Remember that the interest rate cannot fall below zero. The longer it remains close to zero, the less faith the population holds in the value of the dollar.
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The Risks of Quantitative Easing?
QE is not without its share of risks. In fact, it is a highly controversial issue because of the specific risks involved.
1. Central banks may actually lose money on their purchases. This results in an increased burden for tax payers. Whether that burden comes immediately, or in the future, the central banks will recover their losses at the tax payers' expense.
2. Devaluation of currency is a distinct possibility. While some would argue that this is a "the sky is falling" argument, there is precedence for the argument, recent precedence. With the Federal Reserve pumping $85 billion (yes with a "B") into the economy each month, it's not as far-fetched as some would have the public believe).
3. It could destabilize, rather than repair, the economy. This is always the risk when outside forces begin working to manipulate the economy. The longer interest rates hover near zero, the lower confidence, globally, in the economy grows.
Unintended consequences can sometimes hurt just as much as the damage to the economy the central banks were attempting to repair. Another potential, yet significant side effect of this manipulation is that inflation could rise.
This is particular problematic if too much money is distributed into the economy too quickly. Suddenly there's an increase in demand for products that offer a limited supply. This causes prices of these goods, products, and services to increase.
Ultimately, quantitative easing is great in theory. In practice, however, the risks far outweigh the rewards of long-term QE. Moderation is the key and this should be a last-ditch effort to salvage the economy rather than the first play.
- Swift action needed to curb tapering impact on emerging markets: http://blogs.reuters.com/great-debate/tag/quantitative-easing/
- What is Quantitative Easing? http://www.moneycrashers.com/what-is-quantitative-easing-explained/
- Definition of quantitative easing: http://lexicon.ft.com/Term?term=quantitative-easing
- Quantitative Easing: http://www.investopedia.com/terms/q/quantitative-easing.asp