ChainWhat it assumes · how to break it
Start
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
Best link to attack
Assumes: Wealth gains are spent.
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.
End
Real GDP growth rises, as long as there is spare capacity. Near full capacity, more of the effect shows up as inflation.
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Questions this answers
- Explain how quantitative easing might increase economic growth.
- Assess the effectiveness of quantitative easing as a policy to stimulate an economy.
- Discuss the possible costs of quantitative easing.
Diagram
AD/AS with a Keynesian LRAS: AD shifts right in the flat section, so real output rises with little change in the price level.
Reverse and related
Quantitative tightening → long-term rates rise → growth slows.