An unconventional monetary policy where the central bank buys government bonds or other financial assets in an effort to stimulate the economy. This is done in an effort to reduce the amount on the market, thereby pushing the price of the assets up. The idea is to lower interest rates, hopefully resulting in increased lending by the commercial banks.
Since the central banks under the Federal Reserve System cannot directly inject currency into the economy, it has to use other methods to increase the number of loans issued. Quantitative Easing is another tool the central banks utilize to try and reach then end.
It was first introduced by Japan in the early 2000s. Due to the major collapse of the real estate market, along with demographic headwinds, the Japanese economy was mired in deflationary pressures. Since QE is formulated to be used in a low inflation environment, this was the ideal test case.
Over the last two decades, most of the major central banks engaged in QE. The results have been mixed with many studies showing QE has minimal impact upon economic conditions.
How Quantitative Easing Works
When a central bank, such as the Fed, decides to engage in QE, it does so through its open market operations. Here, it swaps reserves (central bank money) for securities. This is done through the commercial banking system since hedge funds and insurance companies cannot hold central bank money due to the absence of a master account.
The process starts with the central bank identifying what securities it is interest in. For example, we can isolate 10Y Treasury Bonds. If they want $25 million of them, they can go to a commercial bank and swap $25 million in reserves, which goes on the commercial bank balance sheet. The security is obviously moved to that of the central bank. Of course, due to double-entry accounting, for each asset added, a liability much also be present.
Under this instance, we see the reserve is added to the central banks balance sheet, meant it is net zero. The liability essentially is an I.O.U. to the commercial bank. With this example, the central bank owes either $25 million in cash or have to unwind the swap and give the security back.
Since this is a liability on the central bank's balance sheet, we know it is not legal tender. There is no currency involved at this stage of the process. Focusing upon the Fed, it does not "buy" the securities using USD. Instead, it is a ledger transaction.
How Interest Works
The underlying security will have an associated payment tied to it. This is presented to the holder of the asset. With QE, the central bank is taking the security onto its balance sheet, hence is paid the interest. This is done in the associated currency.
For the commercial bank, the central bank pays interest on the deposits it has on hand. During a QE swap, the reserves placed on the commercial bank balance sheets are considered as part of this. At this time, the Fed, as an example, pays 1% on excess reserves the commercial banks have.
If the 10Y bond pays 2.75% annually, the Fed will pay the commercial bank 1%, netting it a profit of 1.75%.
Unwinding
The reversal of the process can happen in two ways.
Quantitative Tightening - the central bank reverses its monetary policy and does the reverse process. Hence the security will be transferred (sold) back to the commercial bank and the reserve removed.
The security reaches maturity - the central bank receives the cash payment on the government security and forward it to the commercial bank. Once again, the reserve is removed from both balance sheets, creating equilibrium for both parties from an accounting perspective.