Monday, July 13, 2009

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Quantitative easing

I had a nice conversation with someone on answerbag the other day on quantitative easing. The person was having difficulties in understanding the following.

1. Why is the government engaged in active bond buying?

2. How would it cause inflation?

First you need to understand what is a bond and in particularly what is a government bond.

To put it simply a bond is a security that the government will sell to you. In exchange for using your hard earned cash you will earn regular interest payment and your money back when the bond matures. It also means that citizens like us will have to part with your cash, this will decrease the money supply. The money supply is the  amount money in circulation.

However if the government will buy these bonds back it will mean that they are giving us the money back and as a result the money supply will increase. Why would the government do that?

You would remember that ever since the recession starts the government has been decreasing the official interest rate. This is to encourage people and business to take loans and as a result increase consumption and investment. Since consumption and investment is a large part of the economy, the decrease in the interest rate was supposed to kick start the economy, alas the interest rate has fallen to zero and consumption and investment has not increased.

So what can the government do to kick start the economy?

The key is quantitative easing!

The government will continue to inject fresh money in the market by buying bonds from banks at a very low interest rate. Since the interest rate is quite low, it is as if the government is printing money or giving it for free. The hope is that the banks will be forced to give cheap loans to their customers at low rate and as a result consumption will increase.

i think this would be good in the short run, but the fear is that in the long run inflation will increase inflation. That is why the government will try to reverse this bond buying later on by selling bonds.

Do you think this will work? Leave a comment below.
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