Final answer:
Quantitative Easing has the goal of stimulating economic activity but has notable disadvantages including low credit availability, risk of holding 'toxic assets', and mixed evidence of its effectiveness. Exiting the policy can also be challenging and potentially destabilize financial markets.
Step-by-step explanation:
Quantitative Easing (QE) is a monetary policy instrument used by central banks to stimulate the economy by making long-term credit more available, to increase aggregate demand. This policy involves the purchase of long-term government and private mortgage-backed securities. However, while the intentions behind QE are to promote economic activity, several disadvantages have been observed, particularly concerning credit availability.
One of the main disadvantages of QE is the low credit availability to certain sectors of the economy. Despite the increase in the money supply, banks might not always pass this liquidity on to consumers or businesses, often leading to a disparity in credit access. Additionally, the velocity of money, which measures how quickly money circulates through the economy, might not necessarily increase as intended with QE, as banks may hold onto the additional reserves, especially if they are concerned about future economic uncertainty or if the demand for borrowing remains weak.
Another concern is that the assets purchased during QE, particularly mortgage-backed securities, may become problematic to sell off when reversing the policy. These assets, termed 'toxic assets' during the financial crisis, can pose significant risks to the financial system when their values are uncertain. Exiting QE can be challenging, as it involves central banks selling off these securities which could potentially depress their values and lead to financial instability.
The evidence on the effectiveness of QE suggests mixed results. While QE1 showed some success, subsequent rounds such as QE2 and QE3 appeared to be less effective. This points to diminishing returns of QE over time, raising questions about its efficacy as a long-term economic tool.