The operation of monetary policy: Interest rates and how quantitative easing works

Overview

How the Monetary Policy Committee sets Bank Rate and how rate changes reach the real economy and financial sector, then how quantitative easing works through bond purchases, yields and bank reserves.

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

   In quantitative easing, how does the central bank obtain the funds used to purchase assets?

   Model answer

   The central bank creates new money electronically (rather than printing physical currency or borrowing).

2. 2

   What type of financial assets does a central bank primarily purchase during quantitative easing?

   Model answer

   Government bonds (gilts in the UK).

3. 3

   From which institutions does the central bank purchase assets during QE?

   Model answer

   Commercial banks and other financial institutions.

4. 4

   What does the central bank do with the newly created electronic money during QE?

   Model answer

   It uses the money to purchase financial assets from the banking sector.

5. 5

   How do QE asset purchases affect commercial bank reserves?

   Model answer

   Asset purchases increase commercial bank reserves, as banks receive payment for the bonds they sell to the central bank.

6. 6

   Explain what happens to bond prices and yields when the central bank purchases large quantities of government bonds.

   Model answer

   Increased demand for bonds raises bond prices, and since bond prices and yields move inversely, this lowers bond yields.

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