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When interest rates approach the zero lower bound, conventional monetary policy runs out of room and central banks turn to unconventional monetary policy. The most important such tool is quantitative easing (QE), which became a central feature of UK macroeconomic management after 2009. To understand QE you must first understand the money supply, how money is actually created, and the money multiplier — then trace QE's effect on bond yields, asset prices and aggregate demand, and evaluate it critically.
Key Definition: Quantitative easing (QE) is an unconventional monetary policy in which the central bank creates new electronic money (reserves) to purchase financial assets — primarily government bonds (gilts) — from the private sector, in order to raise the money supply, lower yields and stimulate economic activity when the policy rate is already near zero.
| Element | Detail |
|---|---|
| Specification reference | 4.2.4 — Monetary policy (the money supply and its measures; the role of the central bank; quantitative easing and unconventional monetary policy; the effect on AD; evaluation) |
| Where it is assessed | Paper 2 — data-response and a 25-mark essay; Paper 3 (synoptic) — QE linked to inequality, financial stability and the global economy |
| AO1 Knowledge | Define the money supply (narrow/broad), the money multiplier, QE, quantitative tightening, the portfolio-rebalancing channel, the Quantity Theory of Money |
| AO2 Application | Apply QE to an economy at the ZLB; compute a money multiplier; interpret data on gilt yields and asset prices |
| AO3 Analysis | Chains: QE → higher gilt prices/lower yields → portfolio rebalancing → higher asset prices and wealth → higher C and I → AD |
| AO4 Evaluation | Judge QE against weak bank-lending transmission, the inequality effect, asset-bubble risk, unwinding difficulty and the unknowable counterfactual |
Synoptic signpost: QE sits at the intersection of monetary policy, the financial-markets lesson (credit creation) and inequality. Its strongest evaluation point — that it inflates asset prices held disproportionately by the wealthy — is a direct macro-to-micro distribution link that Paper 3 rewards.
Money performs 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 differently depending on which assets are counted:
| Measure | Definition | Includes |
|---|---|---|
| Narrow money (M0/base money) | Notes and coins in circulation plus banks' reserves at the central bank | Physical cash; central-bank reserves |
| Broad money (M4) | Narrow money plus bank deposits (current, savings and time deposits) | All reasonably liquid assets held by households and firms |
In a modern economy the overwhelming majority of money is bank deposits (broad money), not physical cash. Crucially, most money is created by commercial banks when they lend: a new loan simultaneously creates a new deposit on the other side of the bank's balance sheet. The Bank of England set this out explicitly in its 2014 Quarterly Bulletin article "Money Creation in the Modern Economy".
Exam Tip: A common error is to claim banks simply "lend out" deposits savers have placed with them. In reality banks create money endogenously through lending — the act of lending creates the deposit. Stating this (and citing the Bank of England's own 2014 article) signals genuine understanding to an examiner.
The traditional (fractional-reserve) account of credit creation shows how an initial deposit can support a much larger expansion of bank deposits across the system. Suppose banks keep 10% of deposits as reserves and lend the rest, and an initial £1,000 of new reserves enters the system (illustrative, hypothetical figures):
| Bank | New deposit received | Reserves kept (10%) | New loan created (90%) |
|---|---|---|---|
| Bank A | £1,000.00 | £100.00 | £900.00 |
| Bank B | £900.00 | £90.00 | £810.00 |
| Bank C | £810.00 | £81.00 | £729.00 |
| Bank D | £729.00 | £72.90 | £656.10 |
| ... | ... | ... | ... |
| Total | £10,000.00 | £1,000.00 | £9,000.00 |
The total deposits created (£10,000) equal the initial reserves times the money multiplier (1/0.1 = 10). This is the textbook model. In the modern reality the Bank of England stresses, the causation often runs the other way: banks decide how much to lend based on profitable lending opportunities and the policy rate, and the reserves follow. This is exactly why QE — which floods banks with reserves — did not mechanically multiply into a tenfold rise in broad money: without willing borrowers and willing lenders, the reserves simply sat idle.
The money multiplier is the traditional model linking a change in the monetary base to the eventual change in the broad money supply, given that banks hold only a fraction of deposits as reserves (the reserve ratio, r).
Money multiplier=r1
The total change in the money supply from a change in base money is:
ΔMoney supply=r1×Δbase money
Suppose banks hold 10% of deposits as reserves, so r = 0.1, and the central bank injects £50bn of new reserves:
Money multiplier=0.11=10⇒ΔMoney supply=10×£50bn=£500bn
The intuition: a bank lends out most of a new deposit; the borrower's spending becomes someone else's deposit; that bank lends most of it on; and so on, the leakage at each round being the reserves retained. The smaller the reserve ratio, the larger the multiplier.
Exam Tip: The simple money multiplier is a model, not a description of how banks actually behave. In reality lending is driven by loan demand and banks' willingness to lend, not by a mechanical ratio — which is exactly why QE's effect on broad money was weaker than the textbook multiplier would suggest (banks sat on excess reserves rather than lending them on). Acknowledging this gap is a strong evaluation point.
To see why QE affects yields and spending, it helps to recall Keynes's theory of liquidity preference — the demand for money. People hold money (rather than interest-bearing assets) for three motives:
| Motive | Reason for holding money | Main driver |
|---|---|---|
| Transactions | To finance day-to-day purchases | The level of income |
| Precautionary | To cover unexpected needs | Income and uncertainty |
| Speculative | To hold liquid funds while waiting for better asset returns | The interest rate |
The speculative motive is the key to monetary policy. When interest rates (bond yields) are high, the opportunity cost of holding idle money is high, so people hold less money and more bonds; when yields are low, the cost of holding money is low, so demand for money is high. In a liquidity trap — yields already near zero — the demand for money becomes almost perfectly elastic: people are willing to hold any amount of extra money rather than buy bonds offering near-zero returns. This is the deep reason conventional monetary policy loses traction at the zero lower bound: injecting more money barely moves yields because everyone is already content to hoard cash. QE attempts to break this logjam by buying bonds directly and pushing investors out along the risk spectrum (the portfolio-rebalancing channel below), rather than relying on a lower policy rate to do the work.
The first and most direct effect is on gilt prices and yields, which move inversely. By buying large quantities of gilts, the Bank pushes their price up and therefore their yield down. A simple example shows the inverse relationship: a bond paying a fixed £5 coupon priced at £100 yields 5%; if heavy demand bids its price up to £125, the same £5 coupon now yields only 4% (£5 / £125). Lower gilt yields drag down borrowing costs across the economy and set off the portfolio-rebalancing channel below.
flowchart TD
A["Bank of England creates reserves and buys gilts"] --> B["Gilt prices rise, gilt yields fall"]
B --> C["Portfolio rebalancing: sellers reinvest cash in other assets"]
C --> D["Shares, corporate bonds and property prices rise"]
D --> E["Positive wealth effect and lower corporate borrowing costs"]
A --> F["Bank reserves rise (bank lending channel)"]
B --> G["Lower yields weaken sterling (exchange rate channel)"]
A --> H["Signal of commitment to prevent deflation (expectations)"]
E --> I["Consumption and investment rise"]
F --> I
G --> J["Net exports rise"]
H --> I
I --> K["Aggregate demand rises"]
J --> K
1. Portfolio rebalancing. Institutions that sold gilts now hold cash earning nothing, so they reinvest in higher-yielding assets — corporate bonds, equities, property — pushing their prices up and their yields down. This lowers firms' cost of capital and lifts household wealth.
2. Wealth effect. Rising asset prices make holders feel wealthier and more willing to spend — the wealth effect consistent with Modigliani's life-cycle hypothesis. Higher house prices in particular encourage remortgaging and equity withdrawal.
3. Bank-lending channel. QE raises banks' reserves, which could support more lending. In practice this channel proved weak: banks often held the excess reserves rather than lending, especially when wary of borrower creditworthiness or constrained by capital rules.
4. Exchange-rate channel. Higher money supply and lower yields tend to weaken sterling, making exports cheaper and imports dearer, raising net exports.
5. Signalling/expectations channel. Announcing QE signals a credible commitment to support demand and prevent deflation, lifting confidence and reducing deflationary expectations.
The combined effect of these channels is a rightward shift of AD — the same diagrammatic outcome as a conventional rate cut, but achieved when the rate is already near zero.
| Date | Round | Cumulative stock | Context |
|---|---|---|---|
| March 2009 | First purchases | ~£200bn | Global Financial Crisis; Bank Rate at 0.5% |
| 2011-2012 | Further rounds | ~£375bn | Eurozone crisis; weak recovery |
| August 2016 | Post-referendum round | ~£435bn | Brexit-vote uncertainty |
| March-June 2020 | COVID rounds | ~£745bn | Pandemic shock |
| November 2020 | Final COVID round | ~£895bn | Second wave |
By late 2020 the Bank held roughly £895 billion of assets bought through QE — on the order of 40% of GDP. (Treat the precise figures as well-established approximations.)
Exam Tip: Knowing the broad magnitudes (a peak around £895bn, roughly 40% of GDP, beginning in 2009 at a 0.5% Bank Rate) lets you ground evaluation in context and earns application marks. Frame exact numbers as approximate rather than asserting false precision.
Quantitative tightening is the reversal of QE — shrinking the central bank's stock of purchased assets. It can be:
The Bank of England began QT in 2022, first by passive run-off and then by active sales. QT aims to normalise the balance sheet and remove monetary stimulus, but it must be handled carefully: selling gilts adds to supply and can push yields up sharply, as the September 2022 gilt-market turmoil illustrated.
QE is the best-known unconventional tool, but it sits within a wider toolkit that central banks deploy at the zero lower bound. Understanding these adds breadth to evaluation.
| Tool | What it does | Aim |
|---|---|---|
| Forward guidance | Public commitment about the future path of the policy rate | Lower expected future rates and longer-term market rates today |
| Funding schemes for lending | Cheap central-bank funding for banks conditional on them lending to the real economy | Repair the weak bank-lending channel that limits QE |
| Maturity-switching operations | Buying long-dated and selling short-dated bonds (sometimes called an "operation twist") | Flatten the yield curve and cut long-term borrowing costs without expanding the balance sheet |
| Negative interest rates | A policy rate below zero, charging banks to hold reserves | Push real rates lower and discourage hoarding (used abroad; not adopted in the UK) |
The existence of this toolkit is itself an evaluation point. Critics of QE argue that targeted tools — such as funding schemes that require banks to lend, or fiscal transfers — can deliver demand to the real economy more directly and more equitably than QE, which works diffusely through asset prices and disproportionately benefits the wealthy. Forward guidance, in particular, can amplify QE at almost no balance-sheet cost by convincing markets that rates will stay low for a long time, so the two are often used together. The judgement that "QE is best combined with other tools" is more sophisticated than treating QE in isolation.
The theoretical worry that QE might be inflationary rests on the Quantity Theory of Money, formalised by Irving Fisher (1911):
MV=PQ
where M is the money supply, V the velocity of circulation, P the price level and Q real output.
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