How Quantitative Easing Works

Readers Question How is quantitative easing expected to benefit the UK economy looking at the current situation of the economy.

Readers Question: One more, is quantitative easing and stimulus package is the same?

The stimulus package refers to expansionary fiscal policy. This is tax cuts and government spending increases designed to increase aggregate demand through higher government borrowing.

Quantitative easing involves increasing the money supply through the creation of money.

The fear is that the UK economy is declining very rapidly. GDP growth is forecast to be -3.8% this year. Conventional policy (cutting interest rates and cutting taxes) have failed to stimulate the economy. Quantitative easing is being used to avoid the deflationary pressures which threaten the economy.

Quantitative easing involves:

• The Central Bank creates money electronically. (This is similar effect to printing money, except they are increasing bank reserves which don’t need to be printed in the form of cash)
• With this increase in Bank reserves, the Central Bank is using them to buy various securities. These include government bond and corporate bonds.
• Buying these securities achieves two things

1. Banks sell assets for cash. Therefore they see an increase in their liquidity (cash reserves). In theory the bank will then be more willing to lend to customers. This lending will be important for increasing investment and consumer spending.
2. Buying assets reduces their interest rate. Lower interest rates on these securities may also encourage banks to lend rather than keep securities which are paying low interest.

more on Quantitative easing