Quantitative Easing

In the last few weeks, Europe has been in the spotlight of economics affairs as the European Central Bank (ECB) fired the starting gun for Quantitative Easing (QE). The ECB is supposed to pump into the economy of the Union €1.1 trillion. This monetary policy tool has been used before in The USA, The UK and Japan, and fear of deflation has prompted the ECB to put it into practice, in spite of the determined refusal of Germany. Deflation could bring the economic recovery to its knees because a prolonged trend of falling prices would hurt revenues of governments and companies alike, increasing the debt ratio and making it more difficult to pay it back.

The main goal of this policy, in words of the president of the ECB, Mario Draghi, is to lift Europe out of the deflation zone

QE implies the purchase of government bonds and other types of securities from financial institutions to increase the money supply. The increase thereof equals the increase in the central bank liabilities.

The workings of QE can be explained by the following graph

An increase in the money supply produced by QE, ceteris paribus, causes the interest rates to go down. This drop facilitates the borrowing from consumers and businesses, kick-starting the economy.

However, the interest rates were already near zero in the Eurozone when this measure was applied. The massive expansion of the ECB balance sheet is expected to trigger an increase in prices, which can be explained by the following argument:

• There will be more money in the economy

• The same amount of good and services is presumed, or at least it they increase, it will not be enough to offset the increase in the money supply.

• People “compete” for the same amount of good and services, so a higher price is paid.

Nonetheless, QE has also negative impact for others, such as pension funds and savers. As the interest rates fall, the return of savings and investments made by pension funds follow the same trend, hurting the income of pensioners and savers.

The effect of QE depends also on how the money is used. The effect of QE is supposed to ripple through the entire economy, yet many economists argue that the main beneficiaries of QE are the wealthy.  This is essentially due to a large chunk of it is being invested in the property market, skyrocketing the price of houses and making them less affordable for ordinary people as well as  the increase in value of shares in large corporations, making their owners even richer.

QE has to be applied carefully. If central banks just printed out money for pleasure, without measuring and analyzing the economic environment, the result might be uncontrollable inflation