How Quantitative Easing Works – A Layman’s Guide

A Layman’s Guide to Understand Quantitive Easing

Quantitative easing in the simplest of terms is the last resort for the monetary authorities to save an economy that is suffering from a credit crunch.

However, before we can talk about quantitative easing at length, we must understand how money is created and how the conditions that lead to quantitative easing arise, in order to understand it completely.

So, to start off, let us first understand how money is created. Since this article is aimed for the common man and woman, I’ll try to keep the technical jargon at the minimum and try to explain these concepts in the simplest of terms so that everyone can get a clear idea.

1. How is Money Created?

Well, the process of making money is both simple and complicated. Traditionally we used to have gold-based economies where each country had reserves of gold and precious metals and the banknotes and coinage in supply, reflected the value of those reserves. An equal amount of gold or precious metals, therefore, backed each banknote and coin.

In the 1970s, U. S President Richard Nixon decoupled the dollar with the gold standard. The reason for this decoupling was that the U.S dollar was falling rapidly, inflation was rising and the money supply of the dollars was already more than the gold U. S had to back those dollars. So in order to create a new economic system, the gold standard was dropped and when the U.S dropped the gold standard other countries followed suit.  This decoupling of the dollar and gold resulted in the creation of fiat currencies.

2. What is a Fiat Currency?

A fiat currency is a modern currency that is not backed by gold or any precious metal, instead, it is backed by the promise of the respective sovereign government. The US dollar, for example, is backed by the promise of the US government.

Now, most people skim over this part very quickly, but let us spend a few moments to understand the cross over from gold standard to fiat currency.

 A currency is characterised by a few traits that it must possess. It must be

• Rare
• Valuable
• Medium of exchange
• Unit of account
• Store of value

Now both gold-backed currencies and modern fiat currencies have these traits, but slightly differently. Gold-backed currencies drove their value from the underlying gold and we all know that gold is rare and this rarity gives gold its value.

Fiat currencies, however, are not backed by gold so how can they be rare and of value? Aren’t they simply paper? Well, yes, but fiat currencies drive their value from the promise of the sovereign government that issues and backs them up. The US dollar, Australian dollar, British pound, Pakistani rupee and Saudi riyal are all backed by their respective sovereign governments. The government issues the currency in a limit to make it rare and of value.

Now that we have a basic understanding of fiat currencies, let us look at how they are issued.

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3. How is Fiat Money Issued?

The Central bank in any country has the authority to issue a new currency. A country cannot issue new currency according to its wish, well technically it can, but there is always a cost.

In order to issue a new currency, the Central bank of any country creates a debt for the country. For example, the Federal Reserve creates a debt for the US government and this is how money is created. Let us look at this in detail to understand how it works.

The FED credits the account of the US government in its book, thereby creating a debt that the US government has to pay back to the FED. Suppose the FED creates a debt of $1 trillion for the government. This means that the US government now owes $1 trillion to the FED. True, but this also means that $1 trillion have been created as new money by the FED. The US government has been credited with this amount and this means that the US government can now circulate this $1 trillion in the economy.

US Government Credits

To do this, the US government credits the account of various banks and lending institutions with fractions of $1 trillion it received from the FED. Now normally, such an injection of money would be coupled with a lowering of the interest rates so that people can get more money in debt and invest it in the economy to create aggregate demand.

The repayments of these debts will help commercial banks pay off the debt of the US government and this in turn will help the US government pay off the debt it owes to the FED. As of 1^st May 2020, the Federal debt in the US was approximately $19 trillion.

Now, this is how money is created normally. There comes a time when economies keep on lowering their interest rates and then they can no longer reduce the interest rate because they cannot go below the floor. At present, the ED interest rate is 0.25% and this means that the US economy doesn’t have a lot of room right now to lower the interest rates. If the aggregate demand slumps and people stop spending due to a credit crunch because of the Covid-19 pandemic and uncertain financial situation then the US government will not have any monetary or fiscal policy move left to induce aggregate demand.

There simply isn’t enough room to cut the interest rate more. If it goes down from 0.25% to 0.10% for example, the people will not be affected much and no one will bring out their investment to invest in the market at his time in particular.

Therefore, the US government will have to go for Quantitative easing. According to experts, quantitative easing is the last resort or last-ditch move to save a dying economy that has no demand left. In such a scenario, FED will simply start buying U. S government bonds and what this will do is that it will give money to the US government. The money supply will increase; investors who have invested in US treasury bonds will sell their bonds to the FED.

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Conclusion

This is what quantitative theory, in theory, is at least. It may or may not be effective, and that discussion merits an article of its own. For now, simply remember that quantitative easing is a last resort move by the Central bank to buy government bonds and securities to increase the money supply.

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