Quantitative easing (QE) in USA refers to increasing the system's money supply. This occurs when the Central Bank creates new money and spends it on asset purchases. These asset purchases add new money to the system. It is one of the monetary policies in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

Quantitative easing (QE) tapering is the opposite policy of QE (QE). It occurs when the government gradually discontinues its quantitative easing (QE) policy. For example, the US government is currently purchasing assets worth $85 billion on a monthly basis. If the US government reduces asset purchases from $85 billion to $60 billion the following month, this would be considered quantitative easing (QE) tapering. This article will discuss quantitative easing in the USA and its tapering which is important for aspirants preparing for UPSC examination.

What is Quantitative Easing and Tapering?

• Quantitative easing is a process where there is an increase in the money supply by financial institutions with inflow of capital in an effort to promote increased lending and liquidity.
• It is a process which is considered when short-term interest rates are either at or approaching zero, and does not involve the printing of new banknotes.
• Quantitative Easing involves providing more liquid cash with commercial banks as compared to bonds.
• Under the process of quantitative easing, central banks are allowed the asset swap so that the commercial banks will have more cash instead of bonds.
• Tapering refers to the Federal Reserve's policy of unwinding its massive purchases of Treasury bonds and mortgage-backed securities to support the economy during the pandemic.

Need For Quantitative Easing

• It is undertaken when the interest rates have been lowered to near zero (because of either deflation or extremely low money demand).
• When a large number of non-performing or defaulted loans prevent further lending (money supply growth) by member banks.
• When the main inherent risk in the economy is a recession or depression.

Quantitative Easing in USA

• The process of quantitative easing was initially used by the Bank of Japan (BOJ) to curb domestic deflation in the early 2000s.
• However, with the advent of the global financial crisis of 2007–08, similar policies were also used by the United States, the United Kingdom, and the Eurozone during the financial crisis of 2007–2012.
• These nations used quantitative easing as their risk-free short-term nominal interest rates were either at or close to zero.
• USA carried out Quantitative Easing thrice in 2008, 2010 and 2012 called QE1, QE2 and QE3.
• The US Fed Reserve started buying Treasury notes and Mortgage Backed Securities which increased the monetary base of US banks.
• This initiative of buying treasury notes corresponded to a position of more liabilities in the asset-liability portfolio of the Central Banks.

Federal Tapering

• Federal tapering is the gradual reduction in the bond buying program of the US Federal Reserves.
• Federal tapering was undertaken to improve the economic conditions for growth that involved the gradual winding down of central bank activities.
• These activities were primarily aimed at interest rates and investor expectations of what those rates should be in the future.
• The activities included under federal tapering included adjusting the discount rate or reserve requirements, or more unconventional ones, such as quantitative easing (QE).

Importance of Quantitative Easing (QE) Tapering

• Interest Rates: The first and most obvious effect of quantitative easing (QE) tapering will be on interest rates. The effect is almost instantaneous.
  • In fact, quantitative easing (QE) is typically used when interest rates are already at zero and the Central Bank wishes to provide additional stimulus.
  • As a result, quantitative easing (QE) can be viewed as a sub-zero interest rate policy.
  • When quantitative easing (QE) is implemented, the interest rate falls.
  • When the policy of quantitative easing (QE) tapering is implemented, interest rates are expected to skyrocket.
• Deflation and Inflation: The quantitative easing (QE) policy is inflationary. This is due to the fact that it simply expands the economy's monetary base.
  • As a result, inflation occurs and prices skyrocket when there is more money available and it is chasing relatively fewer goods.
  • The United States has undergone three rounds of massive quantitative easing (QE), and prices there are significantly higher than they would have been without the QE policy.
  • As a result, when the opposite policy of tapering quantitative easing (QE) is implemented, inflation is likely to turn into deflation.
  • This is due to the fact that tapering quantitative easing (QE) draws money out of the system. As a result, there is now less money chasing the available goods (compared to before), making every good less expensive.
• Employment: As we already know, the state of the economy's inflation or deflation is closely related to the state of employment.
  • When there is an abundance of money in the economy, the mood is upbeat, and more and more goods are produced.
  • As a result, the economy employs an increasing number of people. As a result, quantitative easing (QE) is positively related to increased employment.
  • When there is less money in the economy, consumer confidence falls, people make fewer purchases, and thus producers produce fewer goods.
  • As a result, a decrease in the money supply leads to a decrease in employment levels. As a result, a tapering policy of quantitative easing (QE) results in lower employment.
• GDP: The total amount of goods produced in an economy equals the Gross Domestic Product (GDP).
  • As a result, there is a clear relationship between the amount of money in the system and the GDP.
  • When quantitative easing (QE) is implemented, an economy's GDP rises and the economy enters the boom phase of the economic cycle.
  • On the contrary, when the policy of quantitative easing (QE) tapering is implemented, an economy's GDP falls, causing the economy to enter a recession.
• Asset Prices: Any economy's money supply is linked to its asset prices.
  • As the money supply expands, everyone in the economy gains purchasing power, and asset prices rise.
  • When the money supply is reduced, however, the opposite occurs, and asset prices tend to fall.
  • This is exactly what is expected to happen in the case of quantitative easing (QE) tapering.

Conclusion

The quantitative easing (QE) tapering policy has been discussed almost every day in the American media and around the world. This is due to the fact that it is both the most important and the most unusual monetary policy of our time. The magnitude of this policy is what gives it such significance. The consequences of this policy will have a long-term and profound impact on a variety of economic parameters.

FAQs

Question. What is Quantitative Easing (QE)?

Question. Why did the USA implement Quantitative Easing?

Question. What does tapering of Quantitative Easing mean?

Question. How does the tapering of QE impact the Indian economy?

Question. What are the potential benefits of tapering for the Indian economy?

MCQs

1. What is the primary goal of Quantitative Easing (QE)?

A) To increase interest rates

B) To stimulate the economy by increasing the money supply

C) To reduce inflation through fiscal policy

D) To decrease government spending

2. What does tapering refer to in the context of Quantitative Easing (QE)?

A) An increase in the pace of bond purchases

B) A complete cessation of bond purchases

C) A gradual reduction in the pace of bond purchases

D) The reversal of QE policies

3. How does the tapering of QE typically affect capital flows?

A) It leads to increased capital inflows to emerging markets

B) It encourages capital outflows from emerging markets to the US

C) It stabilizes global capital flows

D) It has no impact on capital flows

4. What can be a consequence of QE tapering for the Indian economy?

A) A decrease in interest rates in India

B) Strengthening of the Indian rupee

C) Rising inflation due to a stronger US dollar

D) Increased foreign investment in India

5. What is the likely impact of QE tapering on Indian stock markets?

A) Increase in foreign investor interest

B) Increased market volatility and potential capital outflows

C) No significant impact on the markets

D) A boost in stock prices

GS Mains Questions and Model Answers

Q1: Examine the impact of Quantitative Easing (QE) in the USA on emerging economies, particularly India.

Answer: Quantitative Easing (QE) in the USA has significant effects on emerging economies, particularly India, through channels such as capital flows, exchange rates, and global interest rates. QE increases the money supply in the US, lowering long-term interest rates and stimulating global demand for riskier assets in emerging markets. As a result, India experiences capital inflows, which can lower interest rates and spur investment. However, the tapering of QE reduces the flow of money into emerging markets, leading to capital outflows and currency depreciation. The reduction in liquidity can also lead to higher borrowing costs for Indian businesses and consumers. Furthermore, a stronger US dollar due to tapering could result in higher import costs for India, especially for essential goods like crude oil, thereby putting pressure on inflation. While India can benefit from a strong domestic economic recovery and lower inflation in the medium term, QE tapering poses risks of market volatility and economic uncertainty in the short term.

Q2: Discuss the role of the Federal Reserve’s tapering of Quantitative Easing (QE) in shaping India’s monetary policy decisions.

Answer: The tapering of Quantitative Easing (QE) by the Federal Reserve has a profound impact on India’s monetary policy. The Federal Reserve's decision to gradually reduce its asset purchases typically leads to higher global interest rates and capital outflows from emerging markets, including India. This presents a challenge for the Reserve Bank of India (RBI) in managing inflation, exchange rate stability, and economic growth. The RBI may need to adjust its interest rates to offset the impact of rising global rates and maintain financial stability. Additionally, the exchange rate of the Indian rupee may come under pressure as the US dollar strengthens, prompting the RBI to intervene in the foreign exchange market. The RBI must balance these concerns while also addressing domestic inflation and supporting economic growth. The tapering of QE thus requires the RBI to carefully consider its policy stance to mitigate external shocks while fostering domestic stability.

Q3: Analyze the potential benefits and challenges for the Indian economy in light of the tapering of Quantitative Easing by the USA.

Answer: The tapering of Quantitative Easing (QE) by the USA presents both benefits and challenges for the Indian economy. On the positive side, the tapering reflects confidence in the recovery of the global economy, which could lead to higher demand for Indian exports and potentially more stable global markets. It may also lead to a more gradual tightening of global liquidity, which could allow India to adjust more smoothly. However, the challenges are significant. The tapering of QE typically leads to capital outflows from emerging markets, including India, as investors seek higher returns in the US. This could put downward pressure on the rupee, making imports more expensive and leading to inflationary pressures, particularly in sectors like energy and commodities. Furthermore, higher interest rates in the USA could increase borrowing costs for Indian businesses and consumers. Thus, while India may see some benefits from global recovery, the risks of market volatility and external shocks due to QE tapering pose significant challenges.

Previous Year Questions on Quantitative Easing and its Tapering

1. UPSC 2020

Question: "Discuss the impact of Quantitative Easing (QE) and its tapering on emerging economies like India."

Answer: This question required an analysis of the impact of Quantitative Easing (QE) and its tapering on emerging markets, with a focus on the Indian economy, including capital flows, inflation, and exchange rate impacts.

2. UPSC 2019

Question: "Analyze the role of US monetary policy, particularly QE tapering, in influencing India's macroeconomic conditions."

Answer: The question asked candidates to explore how US monetary policy and the tapering of QE influence India’s macroeconomic conditions, particularly in relation to inflation, interest rates, and exchange rates.