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ECB Unleashes Quantitative Easing - How does it work?

Published: January 22, 2015; 15:30 · (FriedlNews)

Today, the ECB finally commenced on a large scale sovereign bond-buying programme. The €60bn monthly asset purchases include covered bonds and asset backed securities. Due to the flood of cheap money, the DAX was boosted. The index increased by up to one per cent to a record high of 10,399.67 points. Quantitative easing is a monetary policy where a central bank creates new money electronically to buy financial assets. The aim is to stimulate an economy when standard monetary policy has become ineffective. How does it work?

ECB Unleashes Quantitative Easing - How does it work? / Picture: © Wikipedia / Soerfm

A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base.

This differs from the more usual policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value.

Expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates.

However, when short-term interest rates reach or approach zero, this method can no longer work.

In such circumstances monetary authorities may then use quantitative easing to further stimulate the economy by buying assets of longer maturity than short-term government bonds, thereby lowering longer-term interest rates further out on the yield curve.

Quantitative easing can help ensure that inflation does not fall below a target.

Risks include the policy being more effective than intended in acting against deflation (leading to higher inflation in the longer term, due to increased money supply), or not being effective enough if banks do not lend out the additional reserves.

According to the International Monetary Fund and various economists, quantitative easing undertaken since the global financial crisis of 2007–08 has mitigated some of the adverse effects of the crisis.