Quantitative Easing. What? Why? How? 3



Good day forex trading koalas.

Today i will like to touch on the concept of Quantitative Easing, QE for short.

Often we hear this mentioned in reports, the media and even speeches by financial leaders. This is an important process conducted by central banks and often impacts the currency of the target economy. Since forex is centered around the trading of currencies, a good understanding of this concept will bring about better analysis and determination of our trading decisions.

What?

Quantitative Easing is the process of increasing the supply of money in an economy. It is usually conducted by central bank.


Why?

Quantitative Easing is usually conducted when there is a shortage of money in an economy. A shortage of money in an economy is a dangerous situation whereby growth and financial processes can grind to a halt. ( For example, new businesses requiring loans but no bank is willing to lend )

It is often a policy of last resort after usual ways to control the money supply such as interest rates have failed. For example during the financial crisis of 2008-2009, the credit crunch of the financial market prompted the US Federal Reserve to implement QE.


How?

Quantitative Easing is conducted by central banks.

  • Firstly, money is created electronically
  • With the newly created money, mass purchases of bonds, etc are conducted
  • As a result of these purchases, banks, investment firms, etc receives a boost to their money supply and this tends to improve liquidity. Therefore more lending activities are stimulated
  • With the increase in ease of lending, businesses receive the needed funds to conduct economic activities which in turns spur the target economy on.


Risk and Impact

Due to the artificial increase of the money supply, inflation may run amok and the target economy’s currency may be diluted. This may result in the fall of the currency’s value. Further implications such as a reduction in foreign investments due to the perceived drop in the country’s credit worthiness may be triggered too.

Conclusion

While there are many variants of the Quantitative Easing process, the general means of how it is conducted and the impact is largely similar. As this process is usually conducted over a period of time, it has the potential to induce medium to long term trends in the affected currency pairs. Therefore it is crucial that one is aware of developments in this aspect.

Trade Safely.

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  • George

    Another very appropriate item. However what is very interesting is the difference between quantitative easing and fractional banking. The history of fractional banking dates back to the middle ages and the early banking system as we currently know it. Forex is even older and dates back to the end of the dark ages when the Knights Templers provided international foreign exchange services with the ability to cash credits abroad to assist pilgrims visiting Jerusalem.

    At the end of the middle ages wealthy individuals would deposit their gold with local goldsmiths and in return receive a receipt. It was possible for one person to transfer their receipt for gold to another in return for goods or services. Thus there were gold receipts in circulation very similar to the bank notes seen today. However as time passed, the goldsmiths noted that no actually checked whether they had all the gold in respect of which they had issued receipts. Thus, they saw no objection to issuing gold receipts in respect of gold that they did not have. The advantage to them was that they were creating a loan for a customer upon which they received interest out of gold which they did not have. For them it was an absolute money for nothing system and lies at the heart of fractional banking. The goldsmiths did carry the risk of default and this would be priced into the interest charged. As commerce became more sophisticated the goldsmiths were replaced by banks. Instead of gold receipts bank notes started to be issued. Again the banks would be issuing bank notes in respect of which they neither had any gold or other security. By the start of the 20th Century, most banks had lost the right to issue bank notes though there remains an exception in Scotland where both the Royal Bank of Scotland and the Bank of Scotland still issue their own bank notes.

    Nevertheless banks continued the fractional banking model by making loans against gold and other securities that they do not have. However from time to time there are runs on banks where those who have deposited money with the bank lose confidence in the bank and seek to withdraw that money. The most classic example of a run on a bank took place in the UK in September 2007 when depositors with Northern Rock plc sought to withdraw their money against security that did not exist. This lead to the Bank of England providing liquidity support to meet the demands of those depositors seeking to withdraw their money.

    Over the years there have been a number of international banking agreements including the various Basel Accords which restrict the level of fractional banking that a bank may undertake.

    However following the financial crisis of 2007/8, banks have had less capital which is required to engage in fractional banking. To compensate for this and to ensure that there is liquidity that would otherwise be provided by fractional banking various forms of quantitative easing have been introduced.

    • Good one George! I liked a lot your explanation and learned with it! Forex is from ancient times indeed! Thanks a lot for your opinion and we hope to see you here often!

  • Excellent article ! I have little or no knowledge about it , but a variation of what it can cause long-term if no properly implemented, is what we saw in 2007-2008 with Housing crisis in USA. Banks started to finance houses and loans with money they did not have and when the people try to claim this money or did had problems paying rates , the bankruptcies was iminent! Without mention the long term consequences of it, that extents until today and God knows where it will go!
    My point of view is that greed have a good part on it!