Question

What is Quantitative Easing (QE) and how does it affect aggregate demand in the economy (if at all)?

tips:Purchase of assets (mainly gilts in UK) by CB with newly created CB liability…..need to explain how this affects deposits and bank reserves. Impact will affect price of bonds and thus long rates. Then follow portfolio adjustment effects, liquidity premium and policy signalling.

Answer 1

Quantitative easing is a process whereby a Central Bank of a country purchases existing government bonds (gilts) in order to pump money directly into the financial system. It is regarded as a last resort to stimulate spending in an economy when interest rates fail to work.

Quantitative easing can work in a number of ways but generally it works by raising asset prices, starting with government bonds, and then spreading out through the wider economy. This gives a boost to bank assets and current bank lending. As quantitative easing lowers the rate of interest to discourage savings and encourage borrowing for spending and investment purposes. It also increases money supply in an economy which ultimately increases the aggregate demand in the form of increased investment and consumption. As aggregate demand is the total of spending in net exports, the national income accounts , government expenditure, investment and consumption. Aggegate demand increases in an expansionary economy and decreases in a deflationary economy. In Quantitative easing Central Banks create new currency which they use for purchasing government and private securities from the public. Hence Quantitative easing is arguably an effective tool for stimulating economic growth by spurring aggregate demand, though it is an expensive strategy in the long run because it could pave the way for runaway inflation. It has become a common monetary policy mechanism but Central Banks need to use it with caution.