central bank

How central bank works during crisis times?

Explore the economic strategy of quantitative easing, where a central bank purchases bonds in order to boost the economy. In March 2020, the COVID-19 pandemic rocked economies worldwide. Millions of people lost their jobs, and many businesses struggled to survive or shut down completely. Governments responded with some of the largest economic relief packages in history. The United States alone spent $2.2 trillion on a first round of relief.

Where did all this money come from?

Most countries have a central bank that manages the money supply and is independent from the government to prevent political interference. The government can implement many types of economic policy, like decreasing people’s taxes and creating jobs through public infrastructure projects, but it actually can’t just increase the money supply. The central bank determines how much money is in circulation at a time.

Why can’t central bank authorize the printing of unlimited money to help an economy in crisis?

They could, but that’s a short-term solution that doesn’t necessarily boost economic growth in the long-term, and can actually hurt the economy. Why?

With more money in circulation, manufacturers of goods like food, clothing, and cars could respond to demand simply by raising prices, rather than manufacturing more of these goods and creating new jobs in the process. This would mean you could no longer buy as much with the same amount of money, a situation known as inflation. A little bit of inflation, about 2% a year, is considered a sign of economic health, but more can quickly derail an economy.

Quantitative easing

In recent decades, central banks have tried an approach called quantitative easing to infuse the economy with cash while maintaining a low risk of severe inflation. In this approach, a central bank increases cash flow by purchasing another entity’s bonds. Anyone can buy bonds from corporations or governments. When you buy a bond, you’re essentially loaning money to the company or government, with the promise that they’ll pay it back later with interest.

This is why buying bonds is sometimes referred to as buying debt. When an individual buys a bond, they’re using money that’s already in circulation. But when the central bank buys a bond, it essentially creates cash. Supplying money that didn’t exist before in exchange for bonds.

History of Central Bank

Both during the 2008-2009 financial crisis and again in 2020, the United States’ central bank, the Federal Reserve, bought bonds from the US government called treasury bonds. Historically, many people have purchased these bonds as a safe form of investment, knowing the US government will pay them back with interest.

Central Bank During COVID-19 Times

In early 2020, the Federal Reserve pledged to buy unlimited treasury bonds. Loaning the U.S. government an unprecedented amount of money. Cash that the government used to fund relief efforts like stimulus checks and unemployment benefits. This isn’t equivalent to simply printing money, though it may sound similar.

Because of the way bonds are priced, by buying so many, the Federal Reserve effectively lowered the return on them. Which incentivizes other investors to lend to riskier entities, like small and midsize companies, in order to get a decent return. Encouraging lending this way should help companies of all sizes borrow money to funnel into projects and hires. Boosting the economy over time in addition to helping the government supply people with urgently needed cash in the short term.

The Federal Reserve’s pledge to buy unlimited government debt has raised some questions and eyebrows.

In theory, this means the government could issue more bonds, which the central bank would purchase. The government could then use the money from the new bonds to pay off the old bonds. Effectively meaning the government never pays back its debt to the central bank. Citing this and other theoretical scenarios, some economists have raised concerns that a central bank buying government debt is a subversion of a system designed to protect the economy.

Others have insisted these measures are necessary, and have so far helped stabilize economies. Though quantitative easing has become a lot more common in recent years, it’s still relatively new. And potential consequences are still unfolding.