What is quantitative easing?

When conventional methods of increasing economic growth has not worked, then central banks may resort to quantitative easing. It is a method of encouraging economic growth by increasing the money supply.

Definition

Central banks increase the supply of money by buying bonds from banks. To raise money to purchase these bonds they print money. When banks sell bonds to the central bank, they increase cash reserves and this should encourage them to lend out money to businesses and individuals. The central bank’s intention is to make borrowing money cheaper to individuals and business so they can spend money and stimulate the economy.

Negative Consequences of quantitative easing

Quantitative easing can devalue the domestic currency as it lowers the yield of financial assets. When central banks buy bonds, they are increase the bond prices, but that lowers the interest yield. This may reduce foreign demand for the domestic currency as currency investors seek higher yield from other currencies.  This will make imports more expensive as the domestic currency is devalued.

QE can also drive up asset prices and cause asset bubbles. As borrowing becomes very cheap it encourages households to become highly leveraged.

Positive consequences of quantitative easing

Devaluing the currency is a positive to exporters as it makes their goods cheaper overseas.

Stocks may be cheaper for foreign investors to purchase due to the exchange rate depreciation. This could potentially drive stock prices up.

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This strategy lowers interest rates which is a positive to loan owners as they may will find their repayments lowered. It can also lead to increase consumer spending as households have more money to spend. Increased spending from consumers can lead to increased earnings from companies. This can then stimulate the stock market.

Quantitative easing can help increase employment as business have access to cheaper loans which they can use to expand their business and generate new jobs.

Lauren Hua is a private client adviser at Fairmont Equities.

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