What is Quantitative Easing?
We all know that the central banks of the countries usually stimulate a slowing economy by cutting interest rates. When interest rates are cut, people are encouraged to spend by borrowing more or discouraging them to save. But when there is a consistent cut in the interest rates and they become almost zero, then this option can be no longer used.
Now, what to do in such circumstances? In such a situation, the central banks resort to pumping money directly into the economy. This "direct pumping of money into economy" is called quantitative easing. Money is directly pumped in the economy by buying bonds, which are usually Government and occasionally Private bonds from banks and financial institutions. In the aftermath of the financial crisis of 2008, the developed countries used quantitative easing to spur growth.
How Quantitative Easing works?
We all know that at a given point of time, there is a fixed amount of money that chases products. The core principle of Quantitative Easing is to put in the system more money to chase the products. When much money changes the same amount of the products, it drives up their prices. In the Quantitative Easing, when the bonds are bought by the Central Bank, the Bond sellers receive money which was NOT the part of the circulation and ultimately this "new" money comes into circulation. When there is more money in the system, there is more demand. Thus the Basic Objective of the Quantitative Easing is to Boost Demand.
But how the demand boost would help?
This is very important question. Here is a simple flowchart that shows how Quantitative Easing works. Please note that this is just simple flowchart for ease of understanding and does not show the whole scenario:
Thus we see that Quantitative Easing is a tool which can potentially ward off deflationary expectations and kick-start an uncertain economy. But this is not as simple as we explain here. In today's globalized environment, the cheap money from developed countries can also flood into the emerging / developing countries and this may cause an asset price rise and possibly a bubble situation. India keeps an eye in increased foreign funds flow, just to avoid such as situation.
What are QE1, QE2 and QE3?
Please note that QE1, QE2 and QE3 are just fashionable terms used for three different instances of Quantitative Easing in United States, out of which one that is QE3 is yet to happen (or may not happen). The expression "QE2" became a "ubiquitous nickname" in 2010. It referred to the second round of quantitative easing by central banks. Similarly, "QE3" refers to proposals for an additional round of quantitative easing following QE2.
The QR2 became fashionable immediately after the economic crisis in 2008. At that time, most governments across the globe had to pump in huge amount of liquidity in the markets to tide over the crisis. However the QE2 was used in the context of American economy those days as the US Federal Reserve Board went for another round of quantitative easing to consolidate the recovery of the American economy.
Now today, a fresh round of U.S. monetary easing dubbed as QE3 is also making news. Prospects for a third round of the Federal Reserve's quantitative easing program (QE3) grew in August 2011 after Chairman Ben Bernanke said the central bank was prepared to ease further if economic growth and inflation falter again.
What are the possible impacts of QE3?
Some analysts say that QE3 would do more harm than good for long-term investors as another flood of easy money into fast-growing emerging economies risks refuelling oil and commodity price inflation, sapping consumption and growth. However advocates of the QE3 say that quantitative easing works best by revaluing financial assets so that there will be a positive wealth effect for U.S. consumers, encouraging them to start spending again.
What would be impact of QE3 on India?
As per studied above, the Quantitative easing III can flood emerging economies with the dollars, thus making the dollars cheaper. This would make the US exports competitive while forcing other related currencies to appreciate on account of increase in capital inflows. Here is a simple indicatory flow chart how it may affect India:
Federal Reserve will push for a fresh infusion of trillions of dollars by buying bonds → bond prices will push up →Yield would come down → bond markets in India would react accordingly.
Here we should also note that some emerging economies such as China and Singapore have almost closed doors, India is likely to see a influx of capital flows. This would push up the stock prices and may eventually call for capital control from regulatory authorities.