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How Does Quantitative Easing Affect Currency Value

qe intro2There has been two schools of thoughts; one that states that quantitative easing affects currency value and the other that denies the later. To better understand how and whether quantitative easing (referred as QE in short) has an effect on currency value, lets look at what QE is;

Quantitative easing is a means used by central banks in an effort to increase the amount of money supply in the economy. This is mainly done by purchasing government bonds and other financial products in the open market thus infusing money into the economy. This is usually done to cure recession by boosting market stability and liquidity. Simply, quantitative easing is one of the expansionary monetary policies used by central banks to boost the economy.

There are two ways that quantitative easing will affect currency value and lead to its depreciation.

1. Lower Interest Rates;

As we know, increase in supply leads to decrease in demand in a normal market. Hence, an increase of money supply in the economy decreases the cost of money i.e Interest rates.

interest rates decrease

A decrease in interest rates will make interest yielding securities in a particular country unattractive. Hence, not only will it be unattractive for foreigners to save money that country’s banks, they will also sell any interest yielding securities they hold to safeguard their investment. By selling that particular countries currency for other foreign currencies, the value of that currency depreciates.

2. Inflation;

Quantitative easing, being an expansionary policy, adds to the money supply circulating in the economy. This in turn means there will be too much money chasing the very same quantity of goods as before. Companies will in turn respond to this increase in demand by raising the prices of goods.
This increase in prices makes domestic goods less competitive in the international market and hence export demand falls. A fall in export demand in turn translates to a fall in the country’s currency hence its depreciation.

Case Study;

The US Federal Reserve began its quantitative easing in 2009 by buying securities in the open market. A month after QE1 announcement, the USD index made its biggest monthly decline (a 10% deep). Below is the Fed’s implementation of quantitative easing;

USA QE

Below shows the decline of the dollar against the yen and euro after the Federal Reserve announced its quantitative easing agenda;

qe usdjpy


qe eurusd

 

From the above, we can agree that quantitative easing affects the value of a currency, and more so; causes its decline. However, there are a few factors that may lead to quantitative easing failing to cause depreciation of a currency as explained below;

1. Lack of increase in the money supply;

At times, quantitative easing may not translate to direct increase in money supply. One reason for this is people choosing to hold the increased money instead of spending. Similarly, banks may not lend reserves gained from quantitative easing, hence no increase in the money supply nor depreciation of the currency. This case scenario happened during UK’s quantitative easing.

2. Liquidity trap;

This is a scenario whereby interest rates cannot go any lower despite an increase in money supply since they are already below the zero level. With interest rates remaining constant, there is no incentive for outflow of money.

liquidity trap

Conclusion;

In normal circumstances, we would expect quantitative easing to affect the value of a currency by causing it to depreciate since it causes an increase in the amount of money circulating in the economy. This was evident when attempted by the US federal reserve. However, various factors may hinder an increase of money supply even after quantitative easing, hence no effect in currency value.

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