Thursday, February 4, 2010

The End of Quantitative Easing

Today the Bank of England announced it was ending its quantitative easing policy, after pumping £200bn into the UK economy. We talked about this in weeks 2 and 3, about the determination of inflation.

At a very simple level, quantitative easing (QE), pumping billions of pounds into the economy, should create inflation because there is a huge increase in the supply of money, while the demand for money remains unchanged.

However, we noted in the lectures that actually, it's the intersection of aggregate demand and aggregate supply that determines inflation. This is because while money can be created by the Bank of England, it has to actually work its way into one of the components of aggregate demand: C, I, G or NX. That's consumption, investment, government spending or net exports.

Because the QE only went to banks to shore up their balance sheets, which had been hit by many bad loans (such as exposure to US sub-prime mortgages), it hasn't actually made it into investment (via more credit being made available to firms to invest), or goverment spending or consumption. Banks have basically sat on the cash so far.

As the BBC article points out, this may cause problems in months and years to come, as the economy picks up, as this money may well be lend out then by banks, and used for Consumption or Investment, and then we may start to see inflation pressures return, and a need to drain this money out of the system again - for example by higher interest rates.

But that's a bridge to be crossed as and when the UK returns to strong economic growth...

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