Central banks in all countries have the task of monitoring the economy and use various measures to stimulate it. Most banks use interest rates to regulate the economy, because lower interest rates boost borrowings and as a result, spending. When the interest rates are high savings get boosted and stop people and companies from borrowing.
At times, however when there is a lot of debt, people curb their spending even when interest rates are low, and this can lead to recessions because the economy is negatively affected. The government in turn, loses out on taxation and has to increase its borrowings to keep up its commitments. This leads to the weakening of the currency, which can increase the cost of imports. It is then that central banks have to step in and look for other measures to control the flow of money. One such step is called quantitative easing, which is meant to reduce the rate of borrowing still further. They do this by creating new money, this being one of the functions of central banks.
Central banks do this by simply adding new money into their account and buying corporate bonds and gilts. This leads to the prices of these instruments rising and yield rates falling. This in turn causes the cost of funds for corporates to reduce, and leads to more spending, which boosts demand and is expected to pull the economy out of a recession. Most of this money finds itself back in banks, and as they have more deposits, they are able to lend more money and thus stimulate the economy.
Quantitative easing has never really been a guarantee of it being able to give the results that central banks intend. At times, these measures have been known to instead, create panic and a loss of confidence in the currency and this can lead to flight of capital, which can be very damaging to any economy. To make it really work, central banks may have to keep on giving themselves money, till the measure really takes effect, but have to be at all times in complete control, so that remedial measures can always be taken.
Reducing rates is the measure that most central banks take to boost the economy by encouraging borrowing, but this can be only done up to a point and can never be near zero. This reduction does not benefit people who are on a fixed rate mortgage, unless they exercise the option of refinancing their mortgage, which has its own costs, which can be quite substantial. When quantitative easing is resorted to, the outcome very much depends on the action taken by banks. If banks hold on to the money it may not get into the system and increase spending. It can only work if they increase lending to individuals and businesses and thus increase chances for the effective circulation of this increased money. As an economic measure, this way of stimulating the economy has a high risk, and can fail if banks do not increase their lending.
Normal economic behavior is only possible when you do not have much debt, or have debt that is manageable and still leaves you with enough to spend. This policy of quantitative easing was first put into place by the Bank of Japan in the year 2000, to help the economy and prevent interest rates falling to uneconomical levels for lenders. Other countries like the United States and the European community have used this policy, with varying degrees of success. This has helped to reduce risks to the system and improved market confidence.
Quantitative easing can cause inflation if too much money is created, but at the same time can lower yields so that lending remains stagnant. There is always a time lag between the announcement of these measures and for their actual effects to be felt in an economy. It can lead to inflationary pressures unless the economy itself is stimulated enough to increase output. When output increases, and consumption kicks in, the currency can still maintain its value, even though there is more of it in circulation. For this it is very necessary that banks continue to increase their lending and not hoard money. Central banks can also increase reserve levels when outputs increase, and reduce any effect of the increased money.