Quantitive Easing....what is it?

Quantitative easing is one of the new, frequently appearing phrases on the news, due to the current financial climate.

Every nation has its own central bank. In the case of England it is the Bank of England. The central bank is not responsible for giving commercial/ business loans. This is the purpose of the commercial banks. The Bank of England can provide loans to commercial banks, at much lower interest rates(even down to .25-.5 %) than commercial banks offer to businesses. The reasoning is that if the commercial banks charged the same interest rate as as the Bank of England charged them, then all the interest acquired from charging businesses would go to pay back the Bank of England.

In times of economic downturn, and especially a severe recession like the world is facing at the moment/ was facing recently, commercial banks become very reluctant to loan money to businesses. The reason for this is that all these banks are afraid that the loan takers that they provide with loans will not be able to pay the money back, as the economic climate seems to be very business unfriendly. The situation is gotten to a point, where banks prefer allocating their funds at 2% after 10 years treasuries, rather than lending money to businesses at rates of 5-8 %, just because treasuries are safer than loans for the time being.

Bank of England sees this situation as a roadblock to the possible boost of the economy in form of investment. Businesses are willing to invest, but commercial banks are unwilling to provide the means. As a plan to encourage the commercial banks to provide investment loans, the Bank of England may wish to resort to quantitative easing.

Commercial bank already have certain amount of toxic assets (toxic assets- assets which expose the holder to large losses, such as bad loans or mortgages). In essence Quantitative easing is the central bank buying out these toxic assets from the commercial banks. The reason for this is to provide commercial banks with money that can be used for loans, at the same time freeing them from the pressure caused by possession of large quantities of toxic assets. At the same time, the central bank invests a lot of money into the 2% after 10years treasuries, in hope to drive down the interest rate of these treasuries. This acts as a disincentive for commercial banks to allocate their funds in treasuries, which means that they need a new place to allocate the money in order to attempt making profits. With the release from toxic assets, they can more confidently loan money to prospective businessman.

There is one major downside to QE, and that is that a lot of it may contribute to depreciating the currency to a level where everyone wants to dispose of it, leading to much more catastrophic consequences than the country was suffering before the decision of the central bank to implement QE.(this paragraph will be explained in more depth in the future)