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Fed to print $1.2 Trillion

The Fed is going to print (technically known as “quantitative easing”) $1.2 trillion to lower rates on mortgages and other consumer debt, spur spending and revive the economy. The Fed will spend up to $300 billion to buy long-term government bonds and an additional $750 billion in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac.

Central banks use interest rate to regulate the economy. Higher interest rate discourages borrowing as saving become more attractive lower interest rates has the reverse effect. As interest approaches zero the effect of interest rate on the economy become muted. As interest rate cannot cut below zero, an alternative to is to use quantitative easing – printing money and use this money buy whatever it likes, in this instance, its the long-term government bond and mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. With the new influx of money from the central bank, the new monies will lead to increase of asset price and the yield or interest rate on that asset will fall.

20090110 money printing-01

20090110 money printing-01 (Photo credit: Wikipedia)

Quantitative easing is perceived to be a high-risk strategy as the central bank does not have a complete picture of the microeconomics situation, stoking just the right level of demand is more of an art than a science. If it is not done aggressively enough, banks will remain unwilling to lend and the crisis could drag on. To some extent that is what happened in Japan when this was tried 10 years ago. On the other hand, if too much money is pumped into the economy it would lead to high inflation or hyperinflation – as seen in 1920s Weimar Germany and modern-day Zimbabwe.