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QE

hello

i was wondering when did the BofE start QE?
and also am I right in thinking that, if QE continues, this should increase AD in the country which could push up the price level and cause more inflation?

Reply 1

MagicNMedicine

The first round of QE was March - November 2009. The second round started October 2011.

If QE works as intended it should increase AD through the channel of business investment, it makes the banking sector more liquid as it takes illiquid assets off the banks and gives them cash so they have more cash to lend, so if that then gets lent to businesses so they can invest and expand production it should increase the investment part of AD.

However because of high levels of uncertainty in the economy businesses are still reluctant to invest and banks are still reluctant to lend so whilst QE should be used, it is not going to have enough impact to get us out of recession.

If it increased AD in the economy to a level where the economy started growing faster than its supply potential and spare capacity got used up (ie the unemployed workers got hired and unused funds for investment were used up) then shortages for input resources would create inflationary pressures. But we are a long way away from that! In practice, when AD starts to approach normal trend levels the BofE will stop QE and start to edge up interest rates.

Reply 2

TPJY

Original post by MagicNMedicine

What do you mean by 'takes illiquid assets off the banks'?

Thanks, that's very helpful!

Reply 3

Classical Liberal

Original post by TPJY

What do you mean by 'takes illiquid assets off the banks'?

Thanks, that's very helpful!

It means the BoE exchanges central bank money (liquid assets) for government/commercial bonds (illiquid assets).

Liquidty is to do with how easy it is to exchange an asset into its monetary value. You can think of it as how easy it is to get the value of an asset to flow as an exchangeable commodity.

An example of an illiquid asset is a house. Suppose you suddenly had a loan shark demanding £100,000. You say to them. My house is worth £100,000, just give me some time to sell it. The house is an illiquid asset because it takes a long time to turn the value of the home into actual money.

Compare this to if the loan shark demanded £100,000 and you had £100,000 worth of cash in a vault. The cash is much more liquid than the house because you can quickly pay off the debt.

The first example is a liquidity crisis. A person owns enough assets to pay off their debts. It just is just taking them a long time to turn the illiquid assets into more liquids assets (the most liquid being actual money).

Government/commercial bonds are a bit like houses. They are assets. But somewhat illiquid. Whilst central bank is an asset but is also very liquid.

Reply 4

MagicNMedicine

Original post by TPJY

What do you mean by 'takes illiquid assets off the banks'?

Thanks, that's very helpful!

Classical Liberal is right about the concept of liquidity.

Imagine a mini model of a bank that had just two types of asset, cash and government bonds (that were due to be redeemed for cash in the future on their maturity date). Say your bank had total assets of £1000, of which £100 was cash and £900 was government bonds. The Bank of England then comes in on a QE programme and buys £200 worth of bonds from that bank and pays for it with cash (which it has created).

Now that bank still has £1000 of assets, but its balance sheet has changed to £300 cash, £700 government bonds. It is more liquid. The bank will not earn interest from that cash, if it sits on it it just sits there earning nothing. The only way it can earn interest from that cash is if it lends it out. So the bank is more likely to lend.

However what is actually tending to happen in QE is banks are sitting on most of that cash anyway rather than lending, because although hoarding cash won't earn any interest, its better than lending it to businesses that are going to go under and end up defaulting anyway...