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I was reading about quantitative easing here, where the definition goes like this:

Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

How can QE lower interest rates?

The central bank decides the interest rates for government bonds, right?

So why would it need QE to lower interest rates? Can it not just cut them?

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The central bank does not decide the rates for government bond, it can only influence the rates. The market decides the rates (unless the treasury wants to issue at a huge discount or premium) it needs to comply with the markets expected rate.

As CB buys government bonds, the number of freely floating bonds is reduced and due to the law of supply and demand their price will go up. When the price of a bond goes up its interest rate goes down (as you are earning a lower rate when you buy it since it has fixed cashflows).

Even the fed funds rate is not a rate set by the fed, the fed only sets the target fed funds rate and it takes action to make it likely that banks will lend each other within this range.

*I suggest you read up on the duties of the fed vs treasury, these duties vary from country to country. For example in my home country the central bank issues bonds. However that is not the case in the US, the treasury issues the bonds and they are assets on the balance sheet of the fed. The bonds are liabilities on the treasury balance sheet. You can also read about the fed wants to downsize its balance sheet now.

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  • $\begingroup$ Aren't government bonds paying a fixed interest rate every year? $\endgroup$ – octavian Jul 29 '17 at 13:13
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    $\begingroup$ Most are fixed coupon correct, although you could have TIPS of variable. My statement is misleading, when I said its interest rate goes up that means its IRR or is YTM, but the actual cashflows do not change. However since the price of the bond changed the rate you earn will change even if the cashflows do not (assuming you are a new buyer) $\endgroup$ – Alex Taha Jul 29 '17 at 13:57
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Using the US as an example, the Fed closely controls the Federal funds rate, which is an overnight rate (not the yield on Government bonds). Usually therefore, the yield on government bonds is determined by supply and demand in the marketplace. However when QE is occurring, the Fed becomes a source of demand for these bonds and hence influences their yield in a downward direction.

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How can QE lower interest rates?

Say, if a market has 1000 USD with only 10 citizens in it. Say, everyone is making 100 USD and spending the same. The bank will have 1000 USD as everyone pays using bank.

With QE, Fed will plug in say 200 more USD into this market. Now the total cash in market is 1200 USD with 10 players. Now, everyone can make slightly more than 100 USD. They can spend more too. The cash at bank is now 1200. So banks have more cash now, which could be lent at a lower rate. So interest rates go down.

This is just an example. there are many other considerations too. QE causes deflation. in such a case, interest rates could fall further. If economy stays healthy, it increases inflation in long run, which has more adverse effects, because, this inflation isn't natural. its artificially created by Fed.

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