Central banks’ method of increasing money supply by printing new money and purchasing government securities. The process works as follows:
1. The central bank creates a pre-determined amount of money and uses it to buy government bonds in the market.
2. Because this reduces the supply of government bonds, their prices go up. This means that their yields are reduced.
3. The banks that sold the bonds back to the government now have more money to lend. Additionally, since the yield on bonds is lower, banks can also lower lending rates and stay profitable. Lower lending rates encourage consumers and businesses to borrow. These spur activity in the credit market and boost economic activity.
Higher money supply encourages spending and thus stimulates economic activity. However, an increase in the amount of money in circulation results to a devaluation of the currency. Prices of goods and services will rise, giving rise to inflationary concerns. Depending on the scale of quantitative easing, the rise in prices could erode the value of the currency and undermine the increase in economic activity.