[OmnipotentOmelette]

I am revising about Quantitative Easing as a method of increasing interest rates.

I understand most of the the transmission mechanism/process which causes the increased interest rates. I've been reading this to help: http://www.bankofengland.co.uk/publi...n/qb110301.pdf

I understand that the government/central bank buys assets. What I don't understand is this: (from page 2 of that document if you want to see it in context)

"Higher asset prices mean lower yields, and lower borrowing costs for firms
and households"

How do higher asset prices lead to lower borrowing costs?

Thanks

[Tateco]

Say a government bond originally costs £100 and yields £10. This £10 yield is fixed. QE leads to the purchasing of these bonds, increasing the demand and so the price of these bonds, for simplicity say the price increases to £200. This bond now still yields £10 but costs £200, so now yields 5% instead of the original 10%. These lower interest rates on bonds then filter through the system to mortgages, loans and credit cards leading to reduced borrowing rates.

(Original post by OmnipotentOmelette)
I am revising about Quantitative Easing as a method of increasing interest rates.

I understand most of the the transmission mechanism/process which causes the increased interest rates. I've been reading this to help: http://www.bankofengland.co.uk/publi...n/qb110301.pdf

I understand that the government/central bank buys assets. What I don't understand is this: (from page 2 of that document if you want to see it in context)

"Higher asset prices mean lower yields, and lower borrowing costs for firms
and households"

How do higher asset prices lead to lower borrowing costs?

Thanks

[MagicNMedicine]

(Original post by OmnipotentOmelette)
I am revising about Quantitative Easing as a method of increasing interest rates.

I understand most of the the transmission mechanism/process which causes the increased interest rates. I've been reading this to help: http://www.bankofengland.co.uk/publi...n/qb110301.pdf

I understand that the government/central bank buys assets. What I don't understand is this: (from page 2 of that document if you want to see it in context)

"Higher asset prices mean lower yields, and lower borrowing costs for firms
and households"

How do higher asset prices lead to lower borrowing costs?

Thanks

In practice the assets that the BofE buys are government bonds. This doesn't mean the government is necessarily issuing new bonds that the BofE is buying, they will be buying government bonds that are held by banks. As they are holding onto those bonds, not selling them, they are basically decreasing the supply of bonds on the market and hence increasing their price.

What Tateco is explaining above is that there is an inverse relationship between the price of a bond and the yield. A bond is basically a promise to pay a sum of money at a date in the future. Eg say there's a government bond that promises to pay £100 in a year from now. If you buy that bond for £95 now, then you are effectively getting a yield of 5.26% because 100/95 = 1.0526, so you are investing your £95 at a rate of 5.26% to turn it into £100 in a year's time.

If on the other hand you bought that bond for £98 now, you are getting a yield of 2.04% because 100/98 = 1.0204, you are getting a rate of interest of 2.04%. So this is why when the price of a bond goes up the yield (the rate of interest you are effectively getting by buying it) goes down.

If we were like Greece, then nobody would really want to hold our bonds as they would think we were a high risk of defaulting and never actually paying up on the due date. Say we issued a 1 year bond promising to pay £100 in a year's time, but there was low demand for it and it ended up only selling for £80, then the yield would be 25% because 100/80 = 1.25. This means the government is paying a high rate of interest to borrow money now because for every £80 it gets now it has to pay back £100 in a year's time - a 25% rate of interest.

As for how the yield on bonds transfers to interest rates on other forms of borrowing: lets say you want to borrow some money off me and we're negotiating what rate of interest you're going to pay me. Supposing the yield on government bonds was 5%, then if you say you'll offer me 3%, why should I lend my money to you? I could just use that money to buy government bonds and make 5% on it. So that's a starting point for our negotiation. Now if the yield on government bonds was 2%, then of course I'm interested in lending you money at 3%, because that's better for me than what I'd get buying government bonds.

[OmnipotentOmelette]

(Original post by Tateco)
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(Original post by MagicNMedicine)
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Thanks for your time, that explained it very well!