QE causes a change in the money supply. Steps:
- The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
- Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
- These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
- QE is likely to lead to inflation because banks lend more and increases the money supply (see Quantity Theory of Money). Another reason for inflation is, holding everything else equal (ceteris paribus), more people have more money that they supposedly use for consumption, creating demand pull inflation
Explained by Stephanie Flanders
Stephanie Flanders in the BBC’s economics editor, the link above provides a short video RSAnimate of QE. A summary of the video is as follows:
· The Bank of England creates money and spends it so that there is “extra cash” flowing into the economy. They spend it by buying government bonds or IOU’s (formal definition: documentation confirming that the debt is owed) from financial institutions such as pension funds or insurance companies.
· This puts more money into the economy (higher money supply) because these financial institutions that sold these bonds have more money to spend on new businesses or on housing for example.
· Because of this, it is cheaper for the government to borrow as the BoE pushes up demand for the Treasury’s IOUs and supply of bonds has been reduced. Long term interest rates are lower than they should be making it cheaper for everyone else to borrow as well, because higher demand means more spending and this leads to faster growth.
The last point explains the theory WHY the government uses QE even with the risk of inflation, particularly during recessions. If demand rises, consumption may increase and the economy begins to recover.