Quantitative Easing (QE) is an unconventional monetary policy tool used by central banks to stimulate the economy, particularly during periods of economic slowdown or financial crises. When standard monetary policy, such as lowering interest rates, becomes less effective, central banks may resort to QE to support economic activity.

How does quantitative easing work?

During QE, a central bank, such as the Bank of Canada or the U.S. Federal Reserve, purchases long-term government bonds and other financial assets from financial institutions. This process has several key effects:

1. Increases the money supply: By buying assets, the central bank injects money into the financial system, increasing the overall money supply. This helps ensure that there is ample liquidity available in the market.
2. Lowers long-term interest rates: QE helps push down long-term interest rates by increasing the demand for bonds. As bond prices rise, their yields fall, which in turn lowers borrowing costs for businesses and consumers.
3. Boosts asset prices: As central banks purchase a variety of assets, the increased demand raises the prices of these assets, including stocks and real estate, which can help wealth effects and encourage spending.

Why is quantitative easing used?

Central banks typically turn to QE in times of economic stagnation or deflation, when traditional tools like adjusting the overnight rate have already been exhausted. QE aims to:

• Stimulate borrowing and lending by lowering long-term interest rates.
• Support financial markets and improve liquidity.
• Promote spending and investment by raising asset prices and boosting consumer confidence.

Potential risks and challenges of QE

While QE can be effective in boosting economic activity, it is not without risks:

• Asset bubbles: Prolonged QE can inflate asset prices beyond their fundamental value, leading to potential bubbles in housing or stock markets.
• Income inequality: QE can disproportionately benefit wealthier individuals who hold more financial assets, exacerbating income inequality.
• Inflation: If too much money is injected into the economy, it could lead to inflationary pressures once the economy recovers.

When is QE typically used?

QE is typically employed during:

• Economic recessions
• Periods of very low or zero interest rates
• Financial crises, such as the global financial crisis of 2008 or the COVID-19 pandemic

Central banks must carefully manage QE to avoid negative side effects while ensuring that economic growth and stability are achieved.

Last modified: January 17, 2025