What Is Quantitative Easing and How Does It Work?
What is quantitative easing? Learn how central bank bond purchases can lower borrowing costs, raise aggregate demand and affect output, jobs and inflation.
Quantitative easing (QE) is when a central bank creates money electronically to buy financial assets, usually government bonds. It aims to make borrowing cheaper and encourage spending and investment when economic activity is weak.
This question focuses on the QE element of A Level point 9.4.5 (changes in the money supply). It builds on AS Level topic 4, The Macroeconomy, particularly Aggregate Demand and Aggregate Supply analysis.
How does it work?
A bond is an asset that pays interest to its owner. Under QE, the central bank buys existing bonds from financial institutions and pays by crediting their accounts with newly created central bank money, called reserves. For example, a bank that sells a government bond to the central bank receives reserves in return.
The extra demand for bonds tends to raise their prices and lower their yields (the return buyers receive relative to the price paid). Lower yields can help reduce other interest rates too. Borrowing may then become more attractive to households and firms, encouraging consumption and investment. These are components of aggregate demand (AD): total planned spending in an economy. If AD rises when the economy has spare capacity, real output and employment may rise.
Will it always work?
No. Banks may hold the extra reserves rather than increase lending, and households or firms may be unwilling to borrow even at lower interest rates. If spending does rise, it may also put upward pressure on prices, especially when the economy is close to full capacity.
Common exam mistake: QE does not mean the central bank simply prints notes and gives them to households, or that every increase in bank reserves automatically becomes new lending. Explain the steps between bond purchases and higher spending.
