It is a tool which is used by the central bank of any
country uses so that the banks start to lend each other thereby increasing the
liquidity in the market. The definition is a very easy to understand but the
working is a bit complex.
As we know that banks by their lending activities help the
economy grow. Say if the bank lends money to any organization (which needs it
for capacity expansion), it would lead to creation of more jobs. More jobs
would mean greater consumption and this would lead to increase in the Gross
Domestic Product. But if the bank stops its lending, it could be detrimental to
the whole economy.
In Quantitative Easing, the central bank buys the securities
(of the banks) which could be debt, collateralized loan obligations, bad loans
etc. (Toxic assets). Once the central bank buys the assets, the central bank
directly pumps money into the bank. The central bank prints the money and gives
it to the bank.
The toxic assets go off from the banks financial statements
and with the money that they have got from the central bank can be used for various
purposes.
Now further to this, the banks invest in government
securities (treasury securities) which are risk-less. By Risk-less, it means
that there is virtually no chance of a default. The banks invest some of the
money with them into these government securities because the return is
guaranteed. The central bank goes and
buys the government securities because the more demand that the central bank creates
for these government securities, the lower the yield. And if the yield goes
down, so there would be less incentive for the banks to invest in the
government securities. It forces the banks to look for places to invest (lend)
the money.
The problem with Quantitative Easing is that if this pumping
of money does not work, it would devalue the home currency. On a positive side,
the goods of the country become cheaper and the demand for the goods would help
the economy grow. But on the other side, if the currency is devalued too much,
then the home currency might crash.
Happy reading :)
Comments
Post a Comment