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The Bank of England creates new central bank reserves and uses them to buy government bonds (gilts) from pension funds, insurers and other financial institutions.
1
As a result, extra demand for gilts raises their price, and because bond yields move inversely to price, long-term interest rates fall.
bond yield
bond yield
Assumes: Markets do not expect higher inflation.
But: If investors expect QE to cause inflation, they demand higher yields and long-term rates fall less.
2
This means the institutions that sold gilts look for better returns elsewhere and buy shares and corporate bonds, pushing their prices up too.
portfolio rebalancing
portfolio rebalancing
Assumes: Sellers reinvest rather than hold cash.
But: In a crisis, banks may keep the new reserves rather than lend or invest them.
3
Consequently, borrowing becomes cheaper for firms and for households on fixed-rate mortgages, while rising share and house prices make asset owners wealthier.
wealth effect
wealth effect
Assumes: Wealth gains are spent.
But: Gains go mainly to people who already own assets, who have a lower MPC, so the boost to spending is small and inequality widens.
4
Therefore, consumption and investment rise, so AD shifts to the right.
aggregate demand
aggregate demand
Assumes: Confidence is high enough for people to borrow.
But: When confidence is very low, as in 2009, cheaper credit may not lead to more spending: the liquidity trap.
5
As a result, firms sell more and raise output to meet the extra demand.
output
output
Assumes: There is spare capacity.
But: If firms are already near capacity, they raise prices rather than output.
6
Since labour is a derived demand, firms need more workers to produce the extra output.
derived demand
derived demand
Best link to attack
Assumes: Firms hire rather than use existing staff more.
Assumes: Firms hire rather than use existing staff more.
But: Firms that hoarded labour during the downturn can raise output by working existing staff harder, so hiring lags behind the recovery.
7
This means firms start hiring, so demand-deficient unemployment falls.
cyclical (demand-deficient) unemployment
cyclical (demand-deficient) unemployment
Assumes: The unemployed have the skills firms need.
But: If unemployment is structural, caused by occupational or geographical immobility, extra demand creates vacancies rather than jobs for the unemployed.
End
Unemployment falls.
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Questions this answers
- Explain how quantitative easing might reduce unemployment.
- Assess whether monetary policy can reduce structural unemployment.
- Discuss the effectiveness of QE in supporting employment after a recession.
Diagram
AD/AS: AD shifts right towards full employment output; or labour market: labour demand shifts right.
Reverse and related
Quantitative tightening → weaker demand → unemployment rises.