Since the early 1980's, most Western central banks have made interest rates their target variable for the conduct of monetary policy. Generally speaking, when an economy appears sluggish, a nation's central bank may try to lower interest rates. In doing so, the monetary authority hopes that businesses will take advantage of the lower rates to borrow money in order to finance new projects. From a business's point of view, lowering the rate makes its anticipated cost of financing smaller than the stream of increased revenues they expect as a result of undertaking the project.
If an economy appears to be overheating, which risks inflation, a central bank may instead do the opposite: attempt to raise interest rates so that firms forgo projects that would not be profitable at higher interest rates.
Now, let me try to illuminate what happens when a central bank "changes" interest rates. It's not as though the central bank changes the "price tag" of a loan. Instead, it manipulates the quantity of funds that commercial banks have available for loan-making, in an effort to manipulate the price at which loans are given.
For example, if a central bank wants loans to be cheaper (i.e., if it desires lower interest rates), then it increases the reserves that commercial banks have available from which they can make loans. And the way a central bank does this is by purchasing assets (such as government securities) from a commercial bank, and paying for them by making the commercial bank's reserves increase by the amount of the purchase--by electronically increasing the commercial bank's reserve account that it holds with the central bank. Hopefully, when banks find themselves with more to lend out, the price of a loan--the interest rate--will fall.
Bottom line: a central bank increases the supply of loanable funds banks have on hand in an effort to manipulate the price of a loan downward (bigger supply => lower loan prices). The central bank will continue to buy securities in this manner until it has manipulated the interest rate down to the desired value.
This works in exactly the opposite manner if a central bank wants loans to grow more expensive (i.e., wants to manipulate interest rates upward) in a hot economy that is courting inflationary risk. Instead of buying assets from banks and paying for them by electronically increasing banks' reserve accounts with the central bank, the central bank sells securities to banks--and reduces the banks' reserves as payment.
Bottom line: a central bank decreases the supply of loanable funds banks have on hand in an effort to manipulate interest rates upward (smaller supply => higher loan prices). And the central bank will continue to sell securities in this manner until it has manipulated the interest rate up to the desired value.
Traditionally there have been two major lines of debate regarding the role of a central bank where broader economic fluctuations are concerned. The first is whether a central bank should be involved in such manipulations at all. But let's leave that for another day.
The second debate concerns whether efforts to jumpstart a sluggish economy through low interest rates are as effective as attempts to reign in a hot economy using high loan rates. And the answer is "no."
Think of reigning in an economy through high loan rates as "pulling on a string." Raise interest rates high enough and nobody will borrow. Pulling on a string works.
Now think of cutting targeted loan rates as "pushing" on that same string. Sometimes, when firms are sufficiently pessimistic about future conditions, a nation's banks can't even give loans away (i.e., make loans at an interest rate of zero percent). Pushing on a string sometimes doesn't work.
So what's a central bank to do once they've cut their targets for interest rates as low as rates can be cut, yet the economy is still stagnant?
The answer is a practice called "quantitative easing." What it means is that a central bank can decide to ignore or forget about interest rate targets, and simply continue to purchase assets from banks, thereby adding still more funds to commercial banks' reserves. For example, in addition to cutting its target interest rate to 0.5 percent today, the Bank of England has announced that it will purchase an additional £75 billion of assets (roughly $105 billion) from banks over the next three months.
Some refer to the practice of quantitative easing as "money printing" because central banks have the power to create the funds they use to buy assets ex nihilo -- "from out of nothing." Remember, the payment is made from a central bank to a commercial bank simply through an accounting "blip": electronically making the commercial bank's reserves grow.
Well, on the bright side, the practice of quantitative easing isn't exactly "money printing" like we have seen recently in Zimabawe, where the government has had the printing presses going so much that they've experienced annual inflation recently of 231 million percent, and have needed to print a Z$100,000,000,000,000 bank note (that's 100 trillion, if you lose track of the zeroes). Nevertheless, quantitative easing adds liquidity to the banking system, as would literal money printing.
So, is quantitative easing a good idea? Does it work? We have only one historical test, and the evidence from that episode is unclear. And a serious inflationary or hyperinflationary spiral is a real danger as an unintended consequence.
Perhaps extreme times sometimes warrant extreme measures. But whether we find ourselves in times that are sufficiently extreme to call for "super-pushing on a string" is an open issue indeed.