Quantitative Easing
Before we look at how quantitative easing works it is important to get an idea of how the bond market works. If you haven't already it is advisable to read this article.
Quantitative Easing is a money stimulus used as the traditional tool of a central bank, interest rates, are no longer effective. Essentially the central bank prints money and buys assets with it such as government bonds from private sector holders, thus injecting money into the economy. It is then believed that the bond sellers – households, firms or banks – will buy other assets such as shares or corporate bonds. This will cause the price of the asset to increase, a higher price of assets means a lower yield (remember - [(Interest/Bond Price) * 100]). This lower yield may mean (if it is lower than other asset yields) demand for other assets like bonds and government debt will increase. Therefore there price will rise and the yield will fall meaning the government (and firms) will be able to borrow for less.
They can therefore invest more or spend the money elsewhere. This also increases confidence which should further boost investment and thus AD. Alternatively the bond sellers will increase their consumption which will boost AD and thus encourage growth.
If the recipient (the owner of the bond who the BoE is buying it off of) lives overseas then they may use the money they receive to buy overseas assets in another currency (not Sterling). To do this they would have to convert the sterling to their respective currency. The greater supply of Sterling on the markets would cause the value of it to depreciate which would help UK exports and UK based businesses (as the price of imports would rise).
Quantitative easing should influence expectations about how long the BoE will keep interest rates at their current levels. By undertaking quantitative easing the BoE is signalling that they aren’t going to raise interest rates in the near future. This should lead to private sector banks reducing their interest rates. This is important when the base rate cannot be cut any further.
Fundamentally though, no-one really knows the effects of quantitative easing. It is expected that quantitative easing doesn’t have its optimal effect until 2 years after the programme is initiated. This means its short term effects are minimal (although it does provide a confidence boost). Also it might have a negative effect on the economy as it is effectively printing money and so might lead to inflation.
Page last updated on 20/10/13
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