Transmission Mechanism of Quantitative Easing

Quantitative Easing: How It Works

The Bank of England’s Monetary Policy Committee has been purchasing assets financed by new money that the Bank creates electronically. Often known as Quantitative Easing, this policy is designed to inject money directly into the economy. This is in response to a sharp fall in demand as businesses and consumers reduce their spending. In short, there is not enough money in the economy.

The aim is to boost spending to keep inflation on track to meet the 2% target. Alongside its decisions on asset purchases, the Monetary Policy Committee continues to set bank rates each month.

The bank purchases assets from private sector businesses, including: insurance companies, pension funds, high street banks, and non-financial firms. Most of the assets purchased are government bonds. There is a large market available, so the bank can purchase large quantities of assets fairly quickly. The Bank of England’s injection of money into the economy works through different channels, and has a variety of potential effects. When the bank buys assets, this increases their price, and so reduces their yield. That means the return on those assets falls. This encourages sellers of assets to use the money they receive from the bank to switch into other financial assets, like company shares and bonds. As purchases of these other assets start to increase, their prices rise, which pushes down on yields generally.

Lower yields reduce the cost of borrowing for businesses and households. This, in turn, leads to higher consumer spending and more investment. Of course, higher asset prices also make some people better off, which provides an extra boost to spending on goods and services.

The Bank of England is also buying smaller amounts of private debt, like corporate bonds. These purchases are aimed at improving conditions in capital markets, making it easier for companies to raise money which they can invest in their business.

There’s another way the Bank’s purchase of assets could put money into the economy. Those selling assets to the bank of England deposit more money into their bank accounts. So commercial banks have more funds which they can use to finance new loans, and more bank lending supports spending and investment. But this channel is likely to be relatively weak as banks continue to repair their finances in the wake of the crisis. That’s why the Bank of England s buying most of the assets from firms other than banks.

The extra money the Bank of England is injecting into the economy should increase spending to help keep inflation on track to meet the Government’s 2% target. Without that boost, the amount of money in the economy would be too low, spending would be weaker, and inflation might fall below target. But as perceptions of an improvement in the economy begin to spread, this will stimulate business and consumer confidence. That will help to underpin expectations that policy is beginning to work, which should itself encourage more spending and keep inflation in line with the target. As it sets policy each month, the Monetary Policy Committee will continue to be guided by the outlook for inflation relative to its 2% target. If the Committee thinks inflation looks set to rise above target, it could raise Bank Rate, and sell assets to remove extra money it has put into the economy.

Source: Bank of England Website: https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

Knowledge check: How hot are you on QE?

Explain how the Bank of England Purchasing Assets will stimulate the economy by:

Injecting more money into the economy (Korma):

Increasing the value of assets (Madras):

Decreasing Bond Yields (Vindaloo):