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A lot of people on the Internet refer to quantitative easing (QE) as a form of "legal money printing" when it is actually not. As such, many of these folks would thus erroneously say that QE leads to devaluation of the currency as a result of the increase in the supply of physical money. This is clearly not correct as QE increases electronic credit (in the form of their reserves) in commercial banks (as banks provide treasury bills and mortgage-backed securities in exchange), which they can then lend out to borrowers who require these funds.

QE aims to lower interest rates in the economy. I was wondering if the mechanism by which QE effects a devaluation of the currency is through the lower interest rates? That means to say, does QE cause the USD to depreciate because the lower interest rates disincentivises financial investments in the US. Hence, the demand for the USD falls as a result of less investors seeking for USD to buy US financial assets.

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  • $\begingroup$ Is your first paragraph related to your question? $\endgroup$ – Giskard Jun 11 at 11:25
  • $\begingroup$ @Giskard Yes. It provides what I deem as the incomplete/inexact/slightly inaccurate explanation of how people think QE leads to depreciation. $\endgroup$ – Tan Yong Boon Jun 11 at 13:19
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QE actually can increase money supply in the economy. We have different measures of money supply ranging from $M0-M4$. QE is not physical printing of banknotes so it does not expand $M0$ but it can expand wider money supply.

Following, the St. Louis Fed definition the QE is defined as:

large-scale asset purchases—in the hundreds of billions of dollars range—of, for example, mortgage-backed securities and Treasury securities.

To the extent that these securities are bought with newly created bank reserves (which you even in your question assume) they will actually increase money supply measures beside the most narrow one which only includes physical notes and coins. In addition QE is supposed to also encourage banks to lend more which also further expands money supply.

In fact increase in the money supply is what is supposed to bring interest rates down as interest rates are determined at money market as you can see on the graph below taken from Blanchard et al. Macroeconomics an European Perspective.

enter image description here

Furthermore, when we talk about devaluation we are talking about currencies with fixed exchange rate. Dollar is not under fixed exchange rate regime. Here it is more correct to talk about depreciation not devaluation (see the explanation of differences here).

The value of currency on foreign exchange depends on both money supply and interest rate. A simple basic classroom monetary model of exchange rate can be expressed as:

$$S= m-m_f -\phi (y-y_f)+\lambda(i-i_f) $$

Where $S$ is the exchange rate $m$ is the log of money supply, $y$ log of real output, $i$ interest rate and $f$ denotes foreign country. So QE can lead to depreciation through both its direct effect on money supply and through its effect on interest rates, however whether dollar depreciates or appreciates depends also on what the other economy, relative to which we value dollar, does.

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