Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Querying the nature of quantitative easing


Quantitative easing (QE) involves the central bank creating new money and using it to purchase assets such as government bonds from the private sector. In many ways this behaviour is similar to conventional open market operations in that it increases the supply of money (check out the earlier section ‘Influencing the money supply: Open market operations’). What’s different is that the central bank isn’t trying to reduce the official interest rate (in the UK, the bank rate), because that’s already at or very close to zero.

Instead, QE is meant to stimulate the economy in a number of ways:

Reducing the yield on assets: By buying up large amounts of assets, the central bank hopes to increase their prices. In doing so it decreases the yield on these assets. For example, if QE increases stock prices, the dividend yield on equities falls. Equally, if bond prices increase due to QE, holding bonds is less attractive.


The central bank is attempting to make lending money relatively more attractive than purchasing financial assets. You can think about the return (yield) on financial assets as the opportunity cost of lending money. By acting to reduce the yield, the central bank reduces the opportunity cost of lending money.


Boosting consumption: Related to the point above, if asset prices such as shares and property increase, household wealth also increases, which should increase consumption.


Reducing the real interest rate: The Fisher equation (which we discuss in detail in the following section) links the nominal interest rate (i), the real interest rate (r) and inflation (π):

Rearranging, you can see that the real interest rate is equal to the nominal

interest rate minus inflation:


Policy makers can reduce the real interest rate in only two ways:


Reduce the nominal interest rate.


Increase inflation.

But the nominal interest rate is already near zero, which leaves only the second option. By injecting large amounts of new money into the economy, the central bank can increase inflation. (Read more about how increasing the supply of money leads to inflation in Chapter 5.)

Flooding the financial system with liquidity: Even though the official

interest rate is close to zero in many advanced economies, the rate at which individuals and firms can borrow is substantially higher. Flooding the financial system with liquidity aims to bring all other interest rates in the economy closer to the official interest rate.