quantitative easing

Quantitative Easing (QE) – Cambridge IGCSE/A‑Level Economics (9708) – Money & Banking (Unit 9.4)

1. Money – definition and functions

• Definition: Money is any asset that is widely accepted as a medium of exchange, a unit of account, a store of value and a standard of deferred payment for goods, services and financial obligations.
• Four functions of money
  • Medium of exchange – removes the need for a double coincidence of wants.
  • Unit of account – provides a common measure for pricing and accounting.
  • Store of value – retains purchasing power over time (subject to inflation).
  • Standard of deferred payment – enables contracts and credit to be expressed in monetary terms.

2. Monetary aggregates

Aggregates are used to measure the amount of money in the economy. The Cambridge syllabus refers to the generic series; the UK terminology is shown for illustration.

Aggregate	What it includes	Typical use in analysis
M₀ (monetary base)	Cash in circulation + banks’ reserves with the central bank	Base for the money‑multiplier process; directly affected by QE.
M₁ (narrow money)	M₀ + demand deposits (checking accounts)	Measures money available for day‑to‑day transactions.
M₂ (broad money)	M₁ + short‑term time deposits	Captures money that can be quickly converted into cash.
M₃	M₂ + long‑term deposits and other liquid assets	Used for longer‑term macro‑economic analysis.

3. Quantity‑theory of money (MV = PT)

The quantity‑theory relationship is expressed as

$$ MV = PT $$

• M = money supply (usually M₁ or M₂).
• V = velocity of money – the average number of times a unit of money is spent in a given period.
• P = price level.
• T = real output (transactions or real GDP).

Assuming V and T are constant in the short‑run, an increase in M leads proportionally to a rise in P (inflation). Quantitative easing raises M by expanding the monetary base (M₀).

4. Commercial‑bank functions (relevant to money creation)

• Accept deposits – demand, savings and time deposits.
• Provide loans and advances to households and firms.
• Facilitate payments – cheques, electronic transfers, debit/credit cards.
• Participate in inter‑bank markets (e.g., overnight lending).
• Hold required reserves (r × deposits) with the central bank.
• Fractional‑reserve money creation: Each new loan creates a new deposit, expanding the money supply by the multiplier m = 1/(c+r), where c is the cash‑hold ratio.

5. Central‑bank functions (the link to QE)

• Issue and withdraw currency – controls cash in circulation.
• Maintain monetary stability – targets inflation, output and employment.
• Lender of last resort – provides emergency liquidity to banks.
• Conduct monetary policy – sets the policy interest rate, reserve‑requirement ratio and uses both conventional (OMOs) and unconventional tools (QE, QT).
• Manage foreign‑exchange reserves – influences the exchange rate.

6. Monetary‑policy tools – where QE fits

Tool	Typical use	Effect on interest rates / money supply
Policy (short‑term) interest rate	Standard tool when rates are above the zero lower bound	Lower rates → higher investment & consumption; indirectly raises money supply via increased bank lending.
Reserve‑requirement ratio	Rarely altered; used to change the money multiplier directly	Lower ratio → larger multiplier → higher money supply.
Open‑market operations (OMOs)	Buy/sell short‑term government securities to fine‑tune bank reserves	Purchases increase reserves (expansionary); sales decrease reserves (contractionary).
Quantitative easing (QE)	Unconventional tool when the policy rate is at or near zero (liquidity trap)	Large‑scale purchase of longer‑term assets → big rise in reserves, lower long‑term yields, direct expansion of the monetary base.

7. What is Quantitative Easing?

Quantitative easing is an unconventional monetary‑policy operation in which the central bank creates new reserves and uses them to buy financial assets – normally government bonds, but sometimes corporate bonds or asset‑backed securities – from the private sector.

8. Why QE is used (Cambridge syllabus 9.4.4)

• Stimulate aggregate demand when conventional interest‑rate cuts are exhausted (zero lower bound).
• Avert deflationary spirals and lift the price level.
• Lower long‑term borrowing costs for households and firms.
• Influence the exchange rate – a weaker domestic currency can boost net exports.
• Support financial‑market stability during crises (e.g., liquidity crunches).

9. Mechanics of a QE operation

1. The central bank announces the total amount of assets to be purchased and the time‑frame.
2. It creates electronic reserves in its own account – an increase in the monetary base M₀ (ΔR).
3. It buys assets from banks, pension funds, insurance companies or other financial institutions.
4. Seller institutions receive the newly created reserves, which they can hold as excess reserves or use to extend new loans.

In a simple notation:

$$ \Delta R = \text{QE (value of assets purchased)} $$

10. Transmission channels of QE

• Portfolio‑rebalancing channel: Sellers of bonds shift into riskier assets (equities, corporate bonds), pushing up asset prices and reducing yields.
• Liquidity (bank‑reserve) channel: Higher reserves ease inter‑bank funding pressures, encouraging banks to lend.
• Expectations (forward‑guidance) channel: The central bank signals that rates will stay low for an extended period, shaping firms’ and households’ expectations of future borrowing costs.
• Exchange‑rate channel: An expanded money supply can depreciate the domestic currency, making exports cheaper and imports more expensive.

11. Effect of QE on the money supply

Using the simple money‑multiplier framework:

$$ M = m \times R \qquad\text{with}\qquad m = \frac{1}{c+r} $$

• c = cash‑hold ratio (fraction of deposits kept as cash).
• r = required‑reserve ratio.
• QE raises R (reserves). If the multiplier m stays unchanged, the broader money supply M expands proportionally.
• If banks hold a large amount of excess reserves or borrowers are balance‑sheet constrained, the multiplier may be compressed and the impact on M is muted.

12. Typical QE programmes – United Kingdom example

Round	Announcement date	Assets purchased (bn £)	Primary asset type
QE 1	June 2009	200	UK Government bonds (Gilts)
QE 2	August 2012	60	Gilts and asset‑backed securities
QE 3	November 2016	60	Gilts
QE 4 (COVID‑19 response)	March 2020	200	Gilts and corporate bonds

13. Quantitative tightening (QT)

When the economy recovers, the central bank can unwind QE by:

• Allowing purchased assets to mature without reinvestment (passive QT).
• Actively selling assets back to the market (active QT).

Both actions reduce reserves, raise longer‑term rates and help contain inflationary pressures.

14. Advantages of QE

• Provides monetary stimulus when the policy rate cannot be cut further.
• Quickly lowers long‑term yields, encouraging investment and stabilising house prices.
• Supports the functioning of financial markets during periods of stress.
• Can improve the terms of trade by depreciating the exchange rate.

15. Potential drawbacks and risks

• May create asset‑price bubbles if excess liquidity flows into equities, property or other risky assets.
• Excessive currency depreciation can raise import prices, leading to imported inflation.
• Uncertainty about the timing, speed and communication of QT can destabilise markets.
• If banks retain excess reserves rather than lend, the money multiplier falls and the intended expansion of M is muted.
• Large central‑bank balance‑sheet expansions raise concerns about future fiscal‑monetary coordination.

16. Evaluation – When is QE likely to be effective?

Factors that enhance effectiveness

1. Liquidity trap / zero lower bound: Short‑term rates are already at zero, so conventional policy is exhausted.
2. Well‑functioning financial markets: The central bank can purchase assets without causing severe price distortions.
3. Credible forward guidance: Markets believe the central bank will keep rates low for an extended period, reinforcing the expectations channel.
4. Bank willingness to lend: Healthy balance sheets mean additional reserves translate into new loans.

Factors that limit effectiveness

• Bank balance‑sheet problems (high non‑performing loans) make them reluctant to extend credit despite abundant reserves.
• Very low or already‑anchored inflation expectations reduce the impact of QE on the price level.
• High sovereign‑debt levels may raise concerns about fiscal sustainability, offsetting stimulus benefits.
• International capital flows can quickly neutralise the intended exchange‑rate depreciation.

17. Suggested exam‑style diagrams

• Diagram A – Flow of reserves during QE: Show the central bank creating reserves, purchasing government bonds from commercial banks, and the resulting increase in the monetary base (M₀) on the balance sheets of the central bank and commercial banks.
• Diagram B – Money‑multiplier process: Illustrate how an initial increase in reserves (ΔR) leads to a larger change in the money supply (ΔM) via the multiplier m = 1/(c+r).
• Diagram C – QE impact on the yield curve: Depict a downward shift of long‑term interest rates (flattening of the curve) after a QE announcement.
• Diagram D – Quantity‑theory framework: Show the MV = PT relationship and indicate how an increase in M (through QE) can raise P if V and T are unchanged.

18. Quick recap – Key formulae for the exam

• Quantity theory: MV = PT
• Money multiplier: m = 1/(c+r)
• Money supply from reserves: M = m × R
• Change in reserves from QE: ΔR = QE