Quantitative Easing (QE)

QE causes a change in the money supply. Steps:

1. The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
2. Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
3. These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
4. 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

http://www.bbc.co.uk/news/business-16973560

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. 

The Quantity Theory of Money

The quantity theory of money

·       Explains that a rise in the money supply leads to excess demand, leading to a rise in prices, inflation. To put it simply, too much money chasing too few goods.

·       The quantity theory is a special case of demand pull inflation.

·       The Fisher Equation of Exchange provides evidence for the quantity theory of money.

MV = PT

M = money supply               

The total amount of money in circulation in the economy at any given time.

V = velocity

The number of times the money circulates around the economy at any given time. V is influenced by methods of payments such as cash, bank overdrafts, credit or debit. Methods of payments are limited therefore V remains constant.

P = price level

T = total transactions

The measure of all the purchases of goods and services in the economy. T remains constant because the theory assumes money is a medium of exchange, not a store of value, therefore people spend quickly any money they receive.

If V and T remain constant, they cancel each other out and thus a M = P. This means that a rise in M will create a rise in P, therefore explaining the theory.

Criticisms

Keynesians generally reject the theory because….

1. There are too many assumptions that the theory relies upon. They don’t believe that people quickly spend any money they receive. Instead, people hold money balances if share prices/bonds are likely to fall for example, thus V and T cannot remain constant.

2.  If there is spare capacity in the economy, Keynesians believe that real output and employment will increase, not the price level. However a counter-argument for that would be the Phillips Curve (more on that to come!).

3. If M has increased, the effect it can have on P is limited if V balances out the increase in P. Reflation of the economy can further limit the effect of a rising money supply on the price level.

4. Reverse causation: Inflation causes an increase in the money supply, not the other way round. Cost push inflation occurs and the money supply adapts (by rising) to finance a higher price level set for consumers to pay.

Inflation to be highest rate for 3 years

This article here highlights that inflation CPI is expected, by city forecasters, to hit 4.9% or even as high as 5.1%. Please read the whole article as it contains information about that rate of pensions increases and past inflation, which is very beneficial to know for the exam!

Monetary Policy

Involves the use of interest rates (see Word of the Day) and quantitative easing (changes to the money supply) to achieve the government's policy objectives. Expansionary monetary policy involves decreasing interest rates and increasing the money supply to increase AD and contractionary monetary policy is the opposite; interest rates are increased to deflate the economy and reduce AD.

Monetary policy is set by the Monetary Policy Committe (MPC) who have meetings every first Thursday of each month to set interest rates. The MPC has 9 members, if you want to find out more, click here.

Word of the Day

Money Supply



The total amount of money in circulation in the economy at any given time. See the quantity theory of money for more.

The Quantity Theory of Money

The quantity theory of money

·       Explains that a rise in the money supply leads to excess demand, leading to a rise in prices, inflation. To put it simply, too much money chasing too few goods.

·       The quantity theory is a special case of demand pull inflation.

·       The Fisher Equation of Exchange provides evidence for the quantity theory of money.

MV = PT

M = money supply               

The total amount of money in circulation in the economy at any given time.

V = velocity

The number of times the money circulates around the economy at any given time. V is influenced by methods of payments such as cash, bank overdrafts, credit or debit. Methods of payments are limited therefore V remains constant.

P = price level

T = total transactions

The measure of all the purchases of goods and services in the economy. T remains constant because the theory assumes money is a medium of exchange, not a store of value, therefore people spend quickly any money they receive.

If V and T remain constant, they cancel each other out and thus a M = P. This means that a rise in M will create a rise in P, therefore explaining the theory.

Criticisms

Keynesians generally reject the theory because….

1. There are too many assumptions that the theory relies upon. They don’t believe that people quickly spend any money they receive. Instead, people hold money balances if share prices/bonds are likely to fall for example, thus V and T cannot remain constant.

2.  If there is spare capacity in the economy, Keynesians believe that real output and employment will increase, not the price level. However a counter-argument for that would be the Phillips Curve (more on that to come!).

3. If M has increased, the effect it can have on P is limited if V balances out the increase in P. Reflation of the economy can further limit the effect of a rising money supply on the price level.

4. Reverse causation: Inflation causes an increase in the money supply, not the other way round. Cost push inflation occurs and the money supply adapts (by rising) to finance a higher price level set for consumers to pay.