How Quantitative Easing Works

Editor's Note: You can find our complete library of free investing articles here.

Quantitative easing is one of the bigger arrows in the Fed’s quiver.

Quantitative easing is a monetary policy tool in which a central bank—like the Federal Reserve—floods the market with cash in an attempt to stimulate an economy in recession and to stave off deflation. The idea is that if the central bank floods enough cash into the market, it will set off the following chain of events:

1. Banks and other financial institutions will build up larger and larger cash reserves

2. Banks will finally decide to loosen their lending standards to utilize their excess cash

3. Individuals and companies will start getting the loans they are seeking

4. The economy will begin to recover as people and companies begin to spend again.

“Helicopter Ben” (Federal Reserve Chairman Ben Bernanke) indicated in a speech in 2002 that he would be willing to dump as much cash into the economy through quantitative easing as was necessary to stimulate growth. Quantitative easing involves flooding the market with cash. The question is…how does a central bank—like the Federal Reserve—flood the market with cash?

Quantitative easing requires the central bank to take the following three steps:

1. Cut the short-term interest rate to zero percent

2. Announce how long it will leave the short-term interest rate at zero percent

3. Begin buying long-term securities—like Treasuries, corporate bonds and asset-backed securities


Part 2: The Benefits of Quantitative Easing

Why Would the Federal Reserve Resort to Quantitative Easing?

It seems that during good economic times, all we hear about is how concerned the Federal Reserve is with inflation. We can’t let the economy grow too fast….We can’t let the monetary base get too big….We can’t just print money—the Fed says.

But during bad economic times, all of that seems to change. And during really bad economic times, we even start to hear about quantitative easing. But what does quantitative easing do for the economy?

As you will see in the video, quantitative easing can help consumers, exporters and financial institutions find their way out of a recession.

Quantitative easing has the following three potential benefits:

1. Quantitative easing can lower longer-term interest rates by pushing down yields at the far end of the yield curve.

2. Quantitative easing can lower deflationary expectations by promising to keep interest rates low for an extended period of time.

3. Quantitative easing can stimulate exports by increasing the monetary base.

I’ve scratched the surface of this topic in the article above, but I go into much more detail about what quantitative easing is and how it is implemented in the Understanding The Benefits of Quantitative Easing Videos above.