What Is Quantitative Easing?

By Tim Parker | October 19, 2010 AAA
What Is Quantitative Easing?

Have you noticed that in the world of business, there always seems to be a buzz word making its rounds? Terms like double-dip recession, inflation, unemployment, stimulus, and if we go back a little further, too big to fail, toxic assets and the popular qualifier, "in these economic times …"

Now that we've taken a trip down economic memory lane, let's crown the economic buzzword for September and October of 2010: quantitative easing! Since the Fed will not officially address this issue until their November meeting, it will undoubtedly be front page news into November as well. (To learn more, see Formulating Monetary Policy.)

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What Is It?
Have you noticed that these financial fad terms make their away through media outlets faster than the definition? If you don't know what quantitative easing is, you're not alone. Here's an easy one line definition: The government buys stuff to stimulate the economy.

A Little More Detail
The Federal Reserve (the Fed) is charged with keeping the economy healthy. Like the blood in your body, there is a flow of money that travels from the Fed through the banks, in to your wallet, out to businesses, back to banks and back to the Fed to start the process again. If this process becomes disrupted, it causes severe problems in the economy, just as a clogged artery could cause a heart attack.

If the banks aren't lending money, this flow slows or stops. If the consumer is saving money instead of spending it, businesses aren't seeing a flow of money which causes disruption. Saving is great for our personal finances, but large-scale saving hurts business. The Fed attempts to prevent blockages from occurring.

The Fed does this in two ways. The first is with interest rates: if the flow of money is restricted, they lower the interest rate to encourage consumers to buy and borrow and banks to lend. Right now, the flow is so disrupted by banks not lending money, high unemployment, and more Americans saving that The Fed currently has interest rates at nearly 0%. This means that they have maxed out this tool since interest rates cannot directly go below 0%. (Learn more about the government and the economy in Top 6 U.S. Government Bailouts.)

When this happens, the Fed can set in to motion another tool called quantitative easing. This is simply the government buying assets. They may purchase bonds, T-bills, mortgages or other types of assets. And they do it on a grand scale! QE2 (Quantitative Easing, round two) would pump $1 trillion in to the economy if estimates are correct.

The purchase of these assets cause interest rates to fall, which further stimulates the economy, at least in theory.

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Problems with QE
In order for the Fed to purchase these assets, they have to print more money. OK, they don't actually print it, there's a 21st century way of activating it. Printing more money eventually lowers the value of the dollar and could cause an inflation problem later on.

Next, economies don't normally respond well, in the long term, to artificial engineering. Driving the value of the dollar down could drive up the cost of commodities. According to Robert Lenzner, senior reporter for Forbes Magazine, we can already see these false valuations or "bubbles" by looking at the recent run up in the price of gold.

The other problem with the price of commodities artificially rising is that the average consumer could end up paying more for basic essentials like wheat, sugar, coffee and pork, just to name a few. Remember when the price of gasoline went to $4 per gallon? If the prices we pay for essentials rises, the stimulation of the economy is offset by higher costs.

The Bottom Line
Anything with government roots will have passionate supporters and equally passionate dissenters. We've already had one round of quantitative easing and judging by Bernanke's comments in October, a second round of quantitative easing, being dubbed "QE2" by the financial media, is on the way. (For more, check out 4 Government Interventions: Did They Work?)

For the latest financial news, see Water Cooler Finance: The Beginning Of A Foreclosure Crisis?

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