What is Quantitative Easing? - Definition, History & Effects

Instructor: Noel Ransom

Noel has taught college Accounting and a host of other related topics and has a dual Master's Degree in Accounting/Finance. She is currently working on her Doctoral Degree.

Quantitative easing is the infusion of cash into the economy to stimulate lending and economic growth. A brief history and timeline of the use of quantitative easing is explored in this lesson.

Money Supply and The Federal Reserve Bank

Money supply is the total amount of money in circulation within a country. The money supply includes cash and credit. Cash consists of currency and coins as well as the balances in checking and savings accounts. The money supply also includes bank reserves, which is the amount of cash central banks must keep at the Federal Reserve Bank. Central banks hold bank reserves in case of an emergency, such as excessive bank withdrawals. Credit in the money supply consists of loans created by banks. Banks have the ability to make loans from customer deposits. However, when customers make deposits at a bank, the bank is required to add a portion of each deposit to its cash reserves. The fraction of total deposits that banks must put into cash reserves is called the reserve ratio. The reserve ratio is used to limit the amount of money banks can lend.

Definition and History of Quantitative Easing

Quantitative easing is a cash infusion into the economy to stimulate lending and economic growth. The Federal Reserve bank purchases securities such as government bonds from banks. The money banks receive from selling these securities increases their bank reserves. The Federal Reserve requires 10% of bank deposits to remain in a reserve account. If some bank reserves fall below the required limit, the Fed will inject cash into the banks' reserve accounts, thereby increasing the amount of cash banks can use to lend to customers.

History of Quantitative Easing

Quantitative easing was used in 2001 in Japan to counter a severe recession and lack of consumer confidence in the financial markets. Consumers and investors had stopped making large purchase decisions, banks had stopped making loans, and the flow of money throughout the Japanese economy had slowly ground to a halt. Therefore, the Bank of Japan decided to inject cash into the banking system. This process is usually done by purchasing bonds from commercial banks. Theoretically, the more cash is injected into the banking system, the more banks can lend, slowly increasing the flow of money throughout the economy. However, Japanese banks decided to hold on to the cash instead of lending it to consumers and other banks. Everyone wanted to wait until economic conditions improved. Therefore, the efficiency gains anticipated by The Bank of Japan took longer to realize.

The United States experienced quantitative easing in 2008 during the financial and mortgage crisis. The Federal Reserve began to buy back substantial assets in three phases: QE1, QE2, and QE3. The first wave of purchases (during QE1) was intended to stimulate mortgage lending. During QE1, the Federal Reserve bought mortgage-backed securities and long-term government bonds that accounted for more than 80% of the total purchases, according to an analysis by The Market Mogul in 2015. In 2010, the Federal Reserve began a QE2 plan to decrease long-term interest rates slowly by purchasing $600 billion worth of Treasury securities while raising inflation rates to avoid deflation.

The U.S. economy still showed signs of slow growth after QE2. In 2011, the Federal Reserve announced a new fiscal plan called 'Operation Twist.' This plan called for exchanging $660 billion in short-term Treasury securities with $660 billion in long-term bonds. Despite QE1, QE2, and Operation Twist, the economy continued to be sluggish. Therefore, the Federal Reserve introduced QE3. Its objective was to continue to inject cash into the banking system until the markets started showing signs of growth. The Federal Reserve spent almost six years purchasing bonds. In October 2014, the Fed ended QE3 as the economy began to show signs of recovery and employment gains.

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