Monetary Policy: Quantitative Easing and Money Supply

When interest rates approach the zero lower bound, central banks turn to unconventional monetary policy tools. The most significant of these is quantitative easing (QE) — a policy that became a central feature of UK macroeconomic management after 2009. Understanding how QE works, its intended effects, and its limitations is essential for A-Level Economics.

Key Definition: Quantitative easing (QE) is a form of unconventional monetary policy in which the central bank creates new electronic money to purchase financial assets — primarily government bonds (gilts) — from the private sector, in order to increase the money supply and stimulate economic activity.

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The Money Supply

Before examining QE, it is important to understand what the money supply is and why it matters.

Definitions of Money

Money serves four functions: a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. The money supply is measured in different ways depending on which assets are included:

Measure	Definition	Includes
M0 (Narrow money)	Notes and coins in circulation plus bank reserves at the Bank of England	Physical cash, central bank reserves
M4 (Broad money)	M0 plus bank deposits (current accounts, savings accounts, time deposits)	All liquid assets held by households and firms

In the modern economy, the vast majority of money exists as bank deposits (M4), not as physical cash. When a commercial bank makes a loan, it simultaneously creates a new deposit — this is how most money is created in a modern economy. The Bank of England explained this clearly in its 2014 Quarterly Bulletin article, "Money Creation in the Modern Economy".

Exam Tip: Many students incorrectly believe that banks lend out deposits they have received. In reality, banks create money endogenously through lending. The Bank of England's own publications confirm this. Demonstrating this understanding will impress examiners.

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How Quantitative Easing Works

The Mechanism

1. The MPC authorises the Bank of England to create new central bank reserves (electronic money) — this is sometimes colloquially described as "printing money," though no physical money is printed.
2. The Bank of England uses these reserves to purchase government bonds (gilts) from commercial banks, pension funds, insurance companies, and other financial institutions on the secondary market.
3. The sellers receive cash (deposits) in exchange for their gilts. Their bank accounts are credited with the proceeds.
4. This increases the quantity of money (deposits) in the banking system and reduces the stock of gilts held by the private sector.

Intended Transmission Channels

1. Portfolio Rebalancing Effect

When the Bank of England buys gilts, it pushes up gilt prices and reduces gilt yields (bond prices and yields move inversely). Financial institutions that have sold their gilts now hold cash instead. Because cash yields nothing, they seek to reinvest in other assets — corporate bonds, equities, property. This pushes up the prices of these assets too, reducing borrowing costs for companies (through lower corporate bond yields) and creating a wealth effect for households.

2. Wealth Effect

Rising asset prices (shares, property, bonds) make asset-holders feel wealthier. This increases their confidence and willingness to spend — the wealth effect identified by Franco Modigliani (1966) in his life-cycle hypothesis. Higher house prices in particular encourage remortgaging and equity withdrawal.

3. Bank Lending Channel

QE increases commercial bank reserves at the Bank of England. In theory, this provides banks with more funds to lend to households and businesses. In practice, this channel has been relatively weak — banks may choose to hold excess reserves rather than increase lending, particularly if they are concerned about borrower creditworthiness or regulatory capital requirements.

4. Exchange Rate Channel

QE tends to weaken the exchange rate because it increases the supply of domestic currency and reduces domestic interest rates (through lower gilt yields). A weaker pound makes exports cheaper and imports more expensive, boosting net exports and aggregate demand.

5. Signalling / Expectations Channel

The announcement of QE signals that the central bank is committed to supporting the economy and preventing deflation. This can boost confidence and reduce deflationary expectations, encouraging spending and investment.

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QE in the UK: Timeline

Date	Programme	Amount	Context
March 2009	QE1	£200 billion	Global Financial Crisis, Bank Rate at 0.5%
October 2011	QE2	£125 billion (total £325bn)	Eurozone crisis, weak recovery
July 2012	QE3	£50 billion (total £375bn)	Continued economic weakness
August 2016	QE4	£60 billion (total £435bn)	Post-Brexit referendum uncertainty
March 2020	QE5	£200 billion (total £645bn)	COVID-19 pandemic
June 2020	QE6	£100 billion (total £745bn)	Continued COVID impact
November 2020	QE7	£150 billion (total £895bn)	Second wave of COVID

By November 2020, the Bank of England held £895 billion of assets purchased through QE — approximately 40% of GDP.

Exam Tip: Know the key dates and magnitudes. Being able to cite specific numbers (e.g., £895 billion total QE, approximately 40% of GDP) demonstrates strong applied knowledge and will earn marks in context-based questions.

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Quantitative Tightening (QT)

Quantitative tightening is the reversal of QE — the process of reducing the Bank of England's stock of purchased assets. This can occur in two ways: