Qualitative easing

In normal times the Central Bank (Federal Reserve) buys and sells short term government bonds to raise and lower interest rates and to keep inflation/deflation in check. It works like this. The government sells bonds and banks and other buyers pay cash for these bonds which takes cash out of the economy which leads to higher loan rates since supply and demand dictates that when you have less cash to lend you can charge a higher rate. When the government buys bonds it pays cash and puts more cash into the economy and lowers interest rates. The same procedure is used to control inflation since the classic definition of inflation is too many dollars (cash) chasing too few goods. Recently the economy has been so bad that the Federal Reserve has lowered interest rates to zero and can do no more in that area to stimulate the economy so they have chosen something called, “Quantitative Easing”. To understand this first realize that the government has promised they would not just print money and hand it out so instead they have printed money and loaned it to banks at zero interest. The banks in turn use that money to purchase government bonds that pay 2 or 3 percent interest. Now this may not sound like much but understand that all during the 50’s, 60’s and much of the 70’s the banks operated successfully with a one percent margin. They were happy to make loans at one percent over their cost of money. Today they operate at margins of 2 or 3 percent. The question arises as to why the banks aren’t making business and consumer loans which was the intent of giving them free money. The answer is, why should they take the risk associated with private loans, when they can get a guaranteed return from the government at no risk. In Quantitative Easing number one, “QE1” The Fed doled out to the banks 2.1 trillion and in QE2 another 600 billion and this week they are expected to announce QE3. This is where the stimulus money came from. The government borrowed 780 billion from the Fed. The Fed got it by selling bonds to the banks. The government then borrowed 780 billion from the Fed and sent that money out to consumers in the form of tax breaks and various spending programs like solar energy and gimmicks to sell cars by offering good deals for people to get rid of their old cars, “cash for clunkers”. Some say the stimulus didn’t help the economy as it was supposed to do since unemployment remained high but others say that if we hadn’t done it things would be worse. Of course there is no way to determine if that is true or not.