The effectiveness of Quantitative easing
'more money flowing around the economy means more money in poeple's pockets'
Edited by Jed Thirkettle | 3 December 2018

The government has four main macroeconomic objectives. The first is to bring the economy to a state of full employment, which is considered to be an unemployment rate of between two and three percent. The second is to ensure that the country has a balance of payments, essentially meaning that the money spent by an economy is equal to the money received, which avoids adding to the country’s national debt. The third macroeconomic objective is to achieve stable economic growth, and the final objective is a low and stable inflation rate of 2% +/- 1% to accommodate healthy economic growth whilst ensuring prices don’t rise or fall at a rapid rate. 

Quantitative easing is the unconventional form of monetary policy where a central bank, the Bank of England in the UK’s case, will create new electronic money in order to purchase financial assets such as government bonds. When new money is created through quantitative easing, the government can spend more money on financial assets, which means government spending in the economy increases. More money flowing around the economy means there is more money in people’s pockets, so people will spend more due to the feeling of being more wealthy, and this leads to an increase in consumption. However, quantitative easing has an effect on inflation, one of the government’s macroeconomic objectives. Employing this form of monetary policy will cause inflation to rise. This is because new money is ‘made’, so money becomes less scarce and prices rise as a result to accommodate this, which goes against the government’s objective to maintain low and stable inflation. The effect that quantitative easing has on employment is greater the further the economy is from full employment. This is because a greater increase in real output, that will occur when the economy is nowhere near full employment, leads to an increase in employment because, when an economy is producing more, more labour is required so unemployment falls. 

Quantitative easing also affects another of the government’s macroeconomic objectives, the balance of payments. When quantitative easing occurs, real interest rates reduce, which leads to a depreciation in the value of the pound due to reduced demand for sterling. This leads to more competitive UK exports, whilst making imports into the UK more expensive. The UK would be gaining more from exports and spending less on imports, meaning it would be in a current account surplus. However, the financial account, which is the flow of investments in and out of the economy, would weaken due to foreign firms deciding to invest elsewhere as interest rates are higher. As a result, the balance of payments should then sum to zero, yet we know this is rarely the case. 

Overall, quantitative easing is a monetary policy that cannot be employed for a very long period. The extra money “created” cannot be kept in the system, and continuously printing money means that people lose confidence in it whilst it loses value. The pound’s value then depreciates as a result, which will lead to inflation in the economy. This goes against the macroeconomic objective of low and stable inflation; however, quantitative easing does help achieve some other of the government’s macroeconomic objectives. For example, the process stimulates real economic growth in an economy, which is a benefit. It also lowers unemployment by increasing the amount of production, and thus demand for labour, in the economy.

Image sourced under Creative Commons License.  

 

James Routledge 2016