Quantitative Easing

Background

During the current financial market meltdown, banks were holding the collateral for the loans which were considered to be of low quality and when the borrower defaulted, banks were not be able to recover the loan amount. Banks became too much cautious while making the new loans to the businesses. This created the liquidity crunch in the economy due to uncertainty. The money released by the central bank could not reach the business which were cash strapped and need money for the operations; credit market became frozen. The reason is that due to uncertainty banks were not willing to lend the money fearing that businesses will default over the loans.

Moreover, the uncertainty was so much that the banks did not even lend to each other. The central bank cut the federal funds rate to facilitate banks to lend to each other and let the credit markets free up. The rate was reduced to 0-0.25%. Banks started raise the funds at this rate and invest in long term Treasury securities, yielding 2-3% return, which are considered to be safe and add certainty to the repayment. This process returns the money released by the central bank back to itself defeating the purpose of increasing the liquidity in economy. The businesses get deprived from the liquidity.

Added function of Central bank

The pipes which deliver the money from central bank to the business are either broken or clogged. Now what central bank can do? Either increase the flow or mend/create new pipes.

The central bank starts to buy the toxic assets (low quality MBS, CDO, CLO, Bank loans to bankrupt companies, etc.) of the banks which are kept as collateral for existing loans. With the default risk transferred to the books of the central bank, banks can look out for loans to the economy.

Furthermore, central bank starts to buy the treasuries in open market operations. The demand of the treasuries brings the yields down which acts as disincentive to the banks. To generate the revenues, banks start to look out in the wider economy (companies, businessmen, etc.) which can give 5-8%.

With these two processes the central bank can print currency as much as it wants to induce in the economy. This is called Quantitative Easing.

Downside: Even after buying the treasuries from the market and toxic assets from the banks, banks may not loan to the businesses. This will devalue the currency which will make the exports more competitive. But if the currency is too much depreciated, market will start selling it leading the further problems.