What is Quantitative Easing and Why has it been used?
Quantitative easing is a policy introduced by the Bank of England to pump [to date] £375 billion into the economy. It works by the BofE purchasing government bonds (known as Gilts) off private and institutional investors which increases the price of government bonds, thus lowering the yield* and making it cheaper for the government to borrow. When first used it was seen as a form of unconventional monetary policy and was used because the central tool in a monetarists pocket – the use of interest rates to stimulate demand – was ineffective. Put simply, a lower interest rate should encourage spending (stimulate demand, and thus boost output) because consumers can cheaply borrow to spend – assuming there aren’t constraints other than cost preventing them from receiving finance – and firms can borrow to invest. But because interest rates were at near zero [0.5% in the UK] this tool couldn’t be used to further stimulate a deteriorating economy and so new ideas need to be floated. QE had been used in Japan to stave off its recession in the 1990s, and whilst not wholly successful, had prevented a collapsing economy.
*I should point out here that the price of bonds is likely to rise, because there is increased demand for bonds from the central bank whilst private investors are unlikely to reduce their demand sufficiently. I base this assumption on the fact that many institutions are legally required by regulations to have a certain percentage of assets in the form of Gilts. Additionally government bonds are seen as extremely safe, and in times of economic hardship – when a policy of QE is needed – investors will be looking to park their money in safe, liquid assets, even at the expense of return. It should also be noted here that yield is in effect the rate of return (sometimes called the interest rate, but don’t confuse this with the base rate interest rate, set by the Bank of England in the UK). *
The BofE is not only buying short term government bonds, but also long term bonds, pushing the long term yield down and making it cheaper for the government to borrow money for the long-term. This may help to reduce the overall budget deficit because interest rate payments will fall, assuming that the government doesn’t increase the primary budget deficit by spending more or by reducing taxes. On this point, it may be seen as likely that the government would actually decide to increase spending and reduce tax. After all, the opportunity cost of this is lower because the interest rate has fallen as a result of the BofE’s actions. Whether the government decides to spend, or whether to reduce taxes is largely determined by their ideological beliefs. Economic theory tells us that government spending should have a larger effect on the economy in the short run than reducing taxes; although a lot of empirical evidence refutes this. Although, the IMF found that the fiscal multiplier was in the range of 0.9-1.8 just after the Great Recession and Eichenbaum et al find that it is around 4 when at the zero lower bound (liquidity trap); hence government spending ought to have had a positive effect on the economy. But it is also important to remember that government funding may take longer to enact (pass laws, find suitable projects, plan etc) than a tax reduction which could be passed in the Chancellor’s Budget. In short, if the policy of quantitative easing causes expansionary fiscal policy then this is likely to boost the economy; it will also be more effective than monetary policy at the zero lower bound.
Not only will the government interest rate fall but so will overall long term interest rates as a search for yield occurs, lowering rates: the investors who received money from the BofE in purchases of the government bonds will either invest it in other assets – increasing demand and pushing down yields elsewhere, meaning firms find it easier to borrow, hence increasing investment and thus output – or spend it, directly boosting consumption/investment and thus output. The effects of quantitative easing outlined above may well reduce the short-term effects of hysteresis, meaning less unemployment occurs, and potentially – depending on the magnitude – prevent the LRAS curve from shifting leftwards.
Increased spending, whether it arises from the private or public sector, could cause higher inflationary expectations which would lower real interest rates through the Fisher effect (r = i-π). We know that lower real interest rates can boost investment and consumption, and this channel will be pertinent when at the zero lower bound: the point where r = -π because nominal interest rates, i, can fall no lower, since the central bank has reduced them to zero.
A secondary effect of an increase in demand for assets (think houses, government bonds, company bonds and, stocks and shares) is that a wealth effect occurs. People who already own houses and financial assets see their price rise as a result of boosted demand, and feel richer – without even needing to have cashed in their ‘profit’. If they feel richer then they may decide to go out and spend some of that money, perhaps on a luxury good; thus boosting the economy. Unfortunately, there is little evidence to suggest that consumption is a function of this wealth effect, thus not corroborating this story.
If a newly enriched banker decided to purchase foreign assets then he would weaken the domestic currency, and assuming the Marshall-Lerner condition would cause an export boost, demonstrating another channel for QE to boost the economy. For the British economy this probably isn’t that significant as exports don’t respond much to a change in currency valuations (price inelastic in supply).
Quantity Theory of Money
The purchase of bonds by the BofE can also be seen as an increase in M in our velocity equation: MV = PY [M = money supply; V = velocity of money; P = price level; Y = output/real GDP]
If we take V and Y to be fixed in the long run then an increase in M will lead to an increase in inflation. So in the long term we may well expect inflation be higher as a result of quantitative easing. We take Y to be fixed in the long run due to the Classical assumption that we are constrained by our factors of production Y = f(Kbar,Lbar).
We have seen above that in the short run we would hope that output would rise in response to quantitative easing; this is likely to cause some inflationary pressure, but when the economy is in a slump it isn’t likely to be too high nor damaging. But overall, it would appear that the economy should experience some inflationary pressure both in the short run and, perhaps more significantly, in the long run.
However without the use of QE it is quite probable that output would have fallen – interest rates couldn’t fall any lower, the economy was in a slump, and negative expectations may have created a self-fulfilling prophecy – which would have re-enforced hysteresis effects. Plus, we can see from our equation that if M and V are constant and Y falls then P must rise in the short run. Without QE output would fall and hysteresis effects would kick-in, reducing the levels of aggregate supply and shifting the long run aggregate supply curve leftwards. In the long run this means that inflation will be greater – assuming aggregate demand returns to pre-recessionary levels – because supply can’t meet demand. Hence we could conceivably have had both short run and long run inflation, even without the policy of QE.
Has QE been successful?
Many have claimed that QE has been unsuccessful, and put particular blame on the fact that the BofE is purchasing bonds off private investors, whom are usually banks and these entities then decide to store the money rather than lend it out or spend/invest it. The policy may well have been more effective if the Bank simply gave every citizen £X to spend to boost the economy (Helicopter money), rather than try to do this indirectly. Despite these criticisms it is calculated that QE raised the level of real GDP by 1.5% – 2% and increased inflation by between 0.75%-1.5%. Even if these exact numbers are wrong, it shows a positive effect to the policy. Yet, some would argue that it may have been possible to get more bang for your buck spending the £375bn on other policies…