Quantitative Easing - Essay Example

This act expands the excess reserves of banks and lowers the yield since the prices of the financial assets rise (Wieland & Research., 2009). Since this is a type of a monetary policy, it also includes expansionary and contractionary monetary policies. Expansionary policies include those in which the central bank purchases government bonds (short-term) in order to bring down the market interest rate. When interest rates are at zero and traditional monetary policy cannot be brought into play, quantitative easing is used to further boost the economy, and not only are short-term bonds purchased, but long-term bonds are purchased as well, and the yield would be most likely to increase.

(Economist, 2005) This policy helps to keep inflation at the right percentage, neither too low nor too high. However, easing can become over-effective and result in deflation or be ineffective and lead to banks not lending out additional reserves (Economist, 2005). As aforementioned, the central bank imposes a monetary policy by a rise or fall in the interest rate. Then the interest rate target is also achieved by open market operations, which essentially involves the buying or selling of short-term government bonds from financial institutions including banks.

The process involves the central bank lending out bonds, collecting the money from these bonds purchased, and this in turn changes the money supply in the economy and at the same time affects the price of government bonds, even though just the short-term ones. This entire process changes the interbank rates of interest (Fukasawa & Corporation, 2000). A liquidity trap occurs when the central bank cannot change the interest rate. Quantitative easing is then used to boost the economy without referring to the interest rate.

The aim of quantitative easing is to affect the money supply and not the interest rate, which is impossible to reduce in any case. And this is referred to as a “last resort policy” in