Quantitative easing

Overview

Quantitative easing, portfolio rebalancing channel of asset purchases and asset purchase programme work through expectations.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is quantitative easing?

   Model answer

   Quantitative easing is the creation of new central bank reserves in order to buy financial assets, chiefly government bonds, from institutions in the secondary market. It is a way of loosening monetary policy by acting on the quantity and composition of assets held by the private sector rather than by changing the short-term policy rate, and it is used mainly when that rate is already close to its lower limit and cannot usefully be cut further. Its immediate effects are to raise the reserves held by commercial banks, to raise the deposits held by the sellers of the bonds, and to raise bond prices and so lower long-term yields.

2. 2

   Why does a central bank turn to asset purchases when the policy rate is already near zero?

   Model answer

   The policy rate cannot be cut far below zero, because savers can always hold physical cash at a return of zero rather than accept a negative one, so beyond a point cutting further simply drives money out of the banking system. Once the rate is at that floor, the usual instrument is exhausted even if the economy still needs stimulus. Asset purchases work on a different margin: instead of changing the very short rate, they reduce the supply of long-dated safe assets available to private investors and so push down yields further along the curve, and it is those longer yields that matter for mortgages, corporate borrowing and investment decisions. They also expand the money held by the public directly, and signal that policy will remain loose.

3. 3

   Set out step by step how quantitative easing is intended to affect the economy.

   Model answer

   The central bank creates new reserves electronically and uses them to buy government bonds from financial institutions in the secondary market. The sellers receive deposits at commercial banks, so broad money rises, while the commercial banks receive the new reserves. The extra demand for bonds raises their price, and because a bond pays a fixed coupon, a higher price means a lower yield, so long-term interest rates fall. Investors who have sold safe bonds and now hold money look for a better return and buy other assets, so demand for corporate bonds, shares and property rises and their prices rise too, which lowers the cost of capital for firms and raises the wealth of asset holders. Lower yields on domestic assets reduce the attractiveness of the currency, so it depreciates. Firms then find investment projects cheaper to finance, households feel wealthier and can borrow more cheaply, and exporters gain competitiveness, so consumption, investment and net exports rise. Aggregate demand increases, so output and employment rise and, as spare capacity is used up and import prices rise, inflation moves back up towards the target.

4. 4

   Why is it wrong to describe quantitative easing as printing money?

   Model answer

   Two things are wrong with the description. First, no banknotes are involved: what is created is central bank reserves, an electronic balance held by commercial banks, and the quantity of cash in circulation is determined separately by how much the public chooses to withdraw. Second, printing money in the usual sense means financing government spending with newly created money, whereas asset purchases are made in the secondary market from private holders and are exchanges of one asset for another, with the central bank acquiring bonds of equal value in return for the reserves it creates. The operation is also reversible, since the bonds can be sold back or allowed to mature without replacement, whereas money printed to fund spending is not. The distinction matters because the inflationary consequences of an asset swap that can be undone are very different from those of permanent monetary financing.

5. 5

   Why do central banks buy government bonds from private holders rather than directly from the government?

   Model answer

   Buying directly from the government would mean financing public spending with newly created money, which removes the discipline of having to persuade savers to lend and makes the size of the deficit a monetary decision. Historically that route has led to inflation, because a government that can create the money it needs faces no market constraint on spending, and it is prohibited or strongly avoided in most advanced economies for that reason. Purchasing in the secondary market from institutions that already hold the bonds preserves the constraint: the government must still sell its debt to willing buyers at whatever price the market sets. The economic effects on yields and on the money supply overlap considerably, which is why the distinction is sometimes criticised as formal, but it preserves the principle that monetary policy is not at the government's disposal.

6. 6

   Explain the portfolio rebalancing channel of asset purchases.

   Model answer

   Investors hold a mix of assets chosen to balance risk and return. When the central bank buys large quantities of government bonds, it removes safe, long-dated assets from the market and hands the sellers money instead, so their portfolios are now unbalanced, holding more money and less yield than they wish. To restore the balance they buy other assets, and because government bonds are gone, they move towards corporate bonds, equities and property. That extra demand raises the prices of those assets and lowers their yields as well, so the effect spreads from the bonds actually purchased to the wider cost of capital. This is why the policy can lower borrowing costs for firms even though the central bank buys only government debt.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.