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.
