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
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, as spare capacity is used up, firms face rising costs and can raise prices without losing sales.
demand-pull inflation · output gap
demand-pull inflation · output gap
Best link to attack
Assumes: The economy is close to full capacity.
Assumes: The economy is close to full capacity.
But: In 2009 there was a large negative output gap, so the extra demand mostly raised output rather than prices.
6
In addition, lower UK yields push money abroad, so the pound depreciates and the sterling price of imports rises.
cost-push inflation · import prices
cost-push inflation · import prices
Assumes: The depreciation passes through into prices.
But: Importers may absorb part of the rise in their margins, and competition limits how much they can pass on.
End
Inflation rises: QE's main risk if it stays in place while the economy recovers.
Time lag: effects on inflation can take one to two years, so QE that looked safe in a slump can feed inflation once the recovery arrives.
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Questions this answers
- Explain why quantitative easing might lead to inflation.
- Discuss the view that quantitative easing contributed to the rise in UK inflation in 2022.
- Assess the risks of quantitative easing.
Diagram
AD/AS: AD shifts right in the steep section of LRAS near full capacity, so the price level rises more than output.
Reverse and related
Quantitative tightening → tighter credit → inflation falls.