How Quantative Easing Works – for those who aren’t economists

We get technical in the next article in the Remedy business advice series by looking at what Quantative Easing is, in words that ordinary people can understand.

The Bank Of  England’s Monetary Policy Committee has been purchasing assets financed by new money that the Bank creates electronically.

This has come to be known as “Quantative Easing” or QE, and this policy is designed to inject money directly into the economy. This is in response to a sharp fall in demand as businesses and consumers reduced their spending. Put basically – there is not enough money in the economy. The aim is to boost spending to keep inflation on track to meet the 2% target. Alongside its decisions on asset purchases, the Monetary Policy Committee continues to set the Bank Interest Rate each month.

The Bank purchases assets from private sector businesses, including insurance companies, pension funds, high street banks and non-financial firms. Most of the assets purchased are government bonds. There is a large market available, so the Bank can buy substantial quantities of assets quickly. The Bank Of  England’s injection of money into the economy works through different channels and has a variety of potential effects.

When the Bank buys assets, this increases their price but as a result the return on those assets falls. This encourages the sellers of assets to use the money they receive from the Bank to switch into other financial assets like company shares and bonds. As purchases of these other assets starts to increase, their prices rise which pushes down on returns generally. Lower returns reduce the cost of borrowing for businesses and households. This in turn leads to higher consumer spending and more investment.

Higher asset prices will inevitable make some people better off, which provides an extra boost to spending on goods and services. The Bank Of  England is also buying smaller amounts of private debt like corporate bonds. These are bonds that a company issues to raise money effectively in order to expand its business. These purchases are aimed at improving conditions in capital markets, making it easier for companies to raise money which they can invest in their business.

There is another way that the Banks purchases of assets could put more money into the economy. Those selling assets to the Bank Of England deposit more money into their own bank accounts, so commercial banks have more funds which they can use to finance new loans. More bank lending supports spending and investment, but this channel is likely to be relatively weak as banks continue to repair their own finances in the wake of the banking crisis. That’s why the Bank Of England is buying most of the assets from companies other than banks.

The extra money the Bank Of England is injecting into the economy should increase spending to help keep inflation on track to meet the Government’s target of 2%. Without this injection the amount of money in the economy would be too low, spending would be weaker and inflation might fall below the 2% target. As perceptions of an improvement in the economy begin to spread, this will stimulate business and consumer confidence. That will help to underpin expectations that the policy is beginning to work, which should itself encourage more spending and keep inflation within target.

As it sets policy each month, the Monetary Policy Committee will continue to be guided by the outlook for inflation relative to the 2% target. If they think it looks likely to rise above target it could raise interest rates and sell assets to remove the extra money it has put into the economy.


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