Quantitative Easing and Tapering
At times of low economic growth, the central bank is tasked with stimulating the economy. Usually the
central bank lowers the interest rate at which it lends to other banks who in turn lend at cheaper rates to
normal people. This cheap money is expected to drive demand leading to money whizzing around leading
to healthier economy. But the problem comes when this fails to work. What can the government do if the
interest rates are near zero? They surely can’t go below zero, can they?
This calls for unconventional measures to stimulate the economy. In the aftermath of recession, this is
precisely what happened in the US. The interest rates approached zero, but the economic activity was still
below average. The Federal Reserve chairman Ben Bernanke came up with the idea of quantitative
easing. What it means is the fed will buy assets from other banks and entities. These assets could be
mortgage backed securities, government bonds etc. So the price of bonds goes up and yield goes down.
This fuels the money available for commercial banks who in turn will lend to normal people with
increased enthusiasm. It creates a ripple effect with more money flowing around and helping the
economy.
It was tried first by a central bank in Japan to get it out of a period of deflation following its asset bubble
collapse in the 1990. In the US, the Federal Reserve has gone through three rounds of quantitative easing
to help stimulate the economy since November 2008. This increased the size of the Federal Reserve's
balance sheet—the value of the assets it holds—from less than $1 trillion in 2007 to more than $4 trillion
now.
As expected, it led to improve in economic activity in the US. During the easing, there was an inflow of
money into emerging economies like India where there are more attractive investments. Therefore, the
Foreign Institutional investments soared in India.
However there were concerns about...