Traditionally, when the Fed wanted to influence Monetary Policy, ( i.e. change interest rates to influence economic behavior) they sold or purchased government bonds.
When they purchased government bonds, the price of bonds increased, thereby reducing the yield or interest rate. This lowered the cost to borrow and was expected to stimulate the economy.
Similarly to increase the interest rate, they sold bonds which increased the supply, reduced the price and increased the interest rate. This was intended to reduce inflation.
But when interest rates are already low, and the Fed needs to stimulate the economy, they use the tool that we have come to know as Quantitative Easing.
QE 1, QE 2, QE 3 :
Following the 2008 US Financial Crisis, Interest rates were low, but banks were unable to lend any further because of bad loans on their Balance Sheet. The Fed then decided to initiate Qualititative Easing or QE1 in 2010. With newly printed money, the Fed purchased bad loans from banks, thereby injecting money into the economy.
As part of QE 1 in 2010, the Fed purchased $ 1.25 trillion of Mortgage Backed Securities and other bad loan products from banks, thereby increasing money supply in the economy by $1.25 trillion.
QE 2 in 2011 saw another $ 600 billion of purchases with more newly printed money.
QE 3 injected $ 40 bn into the economy, with a hint that interest rates will be held down till mid 2015 or till unemployment comes down to ~7%.
Tapering:
In 2013, unemployment finally began a slow decline from its 4 year high of 8% or higher. At 7.4%, it is still far from the 7% target which the Fed had set for themselves, but the fact that unemployment had started moving from its stubborn perch got the Fed to initiate discussions on tapering ( the opposite of easing - taking the money back gradually without adversely affecting the US economy) and rightly so, because it is also the Fed's responsibility to prevent inflation.
It was just a discussion and an initial one at that. And we are a long way from the 7% unemployment target. The economy needs to create 90,000 jobs every month to just keep the unemployment numbers flat. A 0.4% improvement? I don't think it will happen anytime in 2014.
But unfortunately, it rattled the markets. The US markets. And markets all the way to India and Indonesia.
Related Links:
Monetary Policy
Fiscal Policy
Supply and Demand
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