Quantitative easing explained03/10/2011
Quantitative easing explained
03 October 2011
Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates…
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank’s only option is to pump money into the economy directly. That is quantitative easing (QE).
The way the central bank does this is by buying assets – usually financial assets such as government and corporate bonds – using money it has simply created out of thin air.
The institutions selling those assets (either commercial banks or other financial businesses such as insurance companies) will then have “new” money in their accounts, which then boosts the money supply.
Is this printing money?
These days the Bank doesn’t have to literally print money – it is all done electronically.
However, economists would still argue that QE is the same principle as printing money as it is a deliberate expansion of the central bank’s balance sheet and the monetary base.
How does it work?
The Bank has been conducting reverse auctions for government bonds, in which the sellers compete in order to drive down prices.
The action by the Bank is supposed to have two effects. The first channel is through the direct effect on the banks’ bank accounts. With more money sloshing about in their accounts, the banks may decide to lend more to businesses and individuals, and increase the amount of activity in the economy that way.
The second channel is through the effect on the cost of borrowing. When the Bank buys bonds, it reduces the supply of those bonds in the economy. That should increase the demand for new bonds and, at the same time, make it cheaper for businesses to borrow.
Having taken short-term interest rates as low as possible, the idea would be for the Bank to push down longer-term rates as well, which are the rates that companies and individuals borrow at. These are used by companies making longer-term investments and banks setting mortgages, for example.
In theory if QE works, credit growth should pick up and businesses should find it easier to get credit. That, in turn, should help to stimulate the economy.
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