How Quantitative Easing Spurs Economic Recovery: A Detailed Guide

What Is Quantitative Easing?

Quantitative easing (QE) is a powerful tool used by central banks, such as the U.S. Federal Reserve, to stimulate economic activity when traditional monetary policy options become ineffective. By purchasing securities in the open market, QE aims to lower interest rates and boost the money supply, providing banks with additional liquidity. This increased liquidity encourages lending and investment, thereby supporting economic growth.

The Federal Reserve's QE policies have been pivotal during times of economic distress, such as the 2007–2008 financial crisis and the COVID-19 pandemic, playing a significant role in stabilizing markets and promoting recovery.

How Quantitative Easing Influences Economic Growth

Central banks use quantitative easing when interest rates are near zero, and economic growth slows down. Central banks have limited tools, like interest rate reduction, to influence economic growth. Without the ability to lower rates further, central banks must strategically increase the supply of money.

To execute quantitative easing, central banks buy government bonds and other securities, injecting bank reserves into the economy. By increasing the money supply, QE adds liquidity to banks and further reduces interest rates. This allows banks to lend with easier terms.

While the Federal Reserve influences the money supply, the U.S. Treasury Department manages fiscal policy through government spending and taxation, which can also support economic activity.

QE is a monetary policy tool, though it is often implemented alongside fiscal policy measures.

Evaluating the Effectiveness of Quantitative Easing

Most economists believe that the Federal Reserve’s quantitative easing program helped to rescue the U.S. and the global economy following the 2007–2008 financial crisis; however, the results of QE are difficult to quantify.

Globally, central banks have attempted to deploy quantitative easing as a means of preventing recession and deflation in their countries with similarly inconclusive results. While QE policy is effective at lowering interest rates and boosting the stock market, its broader impact on the economy isn’t apparent.

Commonly, the effects of quantitative easing benefit borrowers over savers and investors over non-investors, so there are pros and cons to QE, according to Stephen Williamson, a former economist with the Federal Reserve Bank of St. Louis.

Potential Pitfalls of Implementing Quantitative Easing

Inflation

As more money enters the economy, inflation risk increases. Central banks stay alert since inflation can lag 12 to 18 months behind the rise in the money supply.

A quantitative easing strategy that does not spur intended economic growth but causes inflation can also create stagflation, a scenario where both the inflation rate and the unemployment rate are high.

Limited Lending

Although banks have more liquidity, central banks like the Fed can't make banks lend more or force businesses and individuals to borrow and invest. This creates a credit crunch, where cash is held at banks or corporations hoard cash due to an uncertain business climate.

Devalued Currency

As QE boosts the money supply, it might devalue the domestic currency. While a devalued currency can help domestic manufacturers because the goods they export become cheaper in the global market, a falling currency value makes imports more expensive, increasing the cost of production and consumer price levels.

Case Studies: Quantitative Easing in Action Worldwide

United States

To combat the Great Recession, the U.S. Federal Reserve ran a quantitative easing program from 2009 to 2014. The Federal Reserve’s balance sheet grew as it acquired bonds, mortgages, and other assets. By 2017, U.S. bank reserves exceeded $4 trillion, offering liquidity to support lending and stimulate economic growth. However, banks held on to $2.8 trillion in excess reserves, an unexpected outcome of the Federal Reserve’s QE program.

In 2020, the Fed announced its plan to purchase $700 billion in assets as an emergency QE measure following the economic and market turmoil spurred by the COVID-19 shutdown. However, in 2022, the Federal Reserve dramatically shifted its monetary policy to include significant interest rate hikes and a reduction in the Fed’s asset holdings meant to sidetrack the persistent trend of higher inflation that emerged in 2021.

Europe and Asia

Following the Asian Financial Crisis of 1997, Japan fell into an economic recession. The Bank of Japan aggressively used QE to tackle deflation and boost the economy, shifting from purchasing government bonds to private debt and stocks. The quantitative easing campaign’s effect was only temporary, as the Japanese gross domestic product (GDP) rose from $4.1 trillion in 1998 to $6.27 trillion in 2012 but receded to $4.44 trillion by 2015.

The Swiss National Bank (SNB) also employed a quantitative easing strategy following the 2008 financial crisis, and the SNB came to own assets that exceeded the annual economic output for the entire country. While economic growth occurred, it's unclear how much the SNB's QE program contributed to the recovery.

In August 2016, the Bank of England (BoE) launched a quantitative easing program to help address the potential economic ramifications of Brexit. By buying £60 billion of government bonds and £10 billion in corporate debt, the plan was intended to keep interest rates from rising and stimulate business investment and employment.

By June 2018, the Office for National Statistics in the United Kingdom reported that gross fixed capital formation was growing at a compound average quarterly rate of 0.2% over the prior 10 years, but at 0.8% excluding the economic downturn, compared with 0.6% for the decade preceding the downturn.

U.K. economists were unable to determine whether or not growth would have been evident without this quantitative easing program.

Explain It Like I'm Five

Think of the financial system like a network of banks that sometimes slows down lending when the economy gets shaky. Quantitative easing is like the central bank stepping in and topping off those banks with extra cash so they feel more comfortable lending again. When lending picks up, businesses can invest, and people can spend, which helps the economy move forward.

The Bottom Line

Quantitative easing is a form of monetary policy in which a central bank, like the U.S. Federal Reserve, purchases securities through open market operations to increase the supply of money and encourage bank lending and investment. QE policies have been implemented globally. However, their impact on a country’s economy is often debated.