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, gilt yields and other UK long-term interest rates fall relative to rates abroad.
interest rate differential
interest rate differential
Assumes: Other central banks are not doing QE too.
But: After 2008 the US, euro area and Japan all ran QE, so the gap between UK and foreign yields changed less.
2
This means investors move funds abroad in search of better returns, increasing the supply of sterling, so the pound depreciates.
capital outflow · floating exchange rate
capital outflow · floating exchange rate
Assumes: Capital flows follow yields.
But: In a crisis investors may move into the safest assets regardless of yield.
3
Consequently, UK exports become cheaper in foreign currency and imports dearer in pounds.
SPICED (in reverse)
SPICED (in reverse)
Assumes: Firms pass the exchange rate change into prices.
But: Exporters may take higher sterling margins rather than cut their foreign prices.
4
Therefore, if demand for exports and imports is price elastic, export volumes rise and spending on imports falls.
Marshall–Lerner condition · J-curve
Marshall–Lerner condition · J-curve
Best link to attack
Assumes: Demand is price elastic.
Assumes: Demand is price elastic.
But: In the short run contracts make demand inelastic, so the current account can worsen before it improves.
End
The current account deficit narrows.
Attack the whole chain: QE also raises AD and incomes, so spending on imports rises. This income effect works against the price effect and may cancel it out.
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Questions this answers
- Explain how quantitative easing might affect the exchange rate.
- Assess the likely impact of a depreciation of sterling on the UK current account.
- Discuss the international effects of quantitative easing.
Diagram
Foreign exchange market for sterling: supply of £ shifts right; the price of £ in dollars falls.
Reverse and related
Quantitative tightening → pound appreciates → current account worsens.