David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

19.5 Monetary control
UK quantitative easing
700
600
500
400
300
200
100
- R index
- M index
0
'° '° ,..__ ,..__ ,..__ 00 00 00 °' °' °'
0 0 0 0 0 0 0 0 0 0 0
. .
I . . I I . .
a. c a. c >- a. c >- a.
0 Q) 0 0 Q) 0 0 Q) 0 0 Q)
(/) (/) (/) (/)
Source: Bonk of England.
action. The consequence of this action was to achieve
steady growth in broad money - notice that there
was no spike in broad money growth. Broad money
was nevertheless 50 per cent higher at the end of
2009 than it had been in mid-2006.
This raises three obvious questions. (a) How did the
Bank achieve this? (b) Why did it want broad money
to grow by 50 per cent when real output was
stagnating? (c) Is inflation just around the corner?
To accomplish quantitative easing, the Bank announced
that it would buy 'safe' bonds from private firms or
government, in quantities that made this the mother
of all open market operations. This put narrow money
into the system. The chart shows that most of this
injection of narrow money, having circulated around
the system a few times, ended up being held by
banks as reserves at the Bank of England. Banks
were still afraid of lending very much. But overall
lending did increase. From May 2008 to July 2009,
banks' reserves increased from £27 billion to
£152 billion, whereas broad money increased from
£ 173 7 billion to £2001 billion - so the £264 billion increase in broad money was caused not only by the
£125 billion in bank reserves. As banks felt a little safer, they lent a little more, thereby raising bank deposits.
Why was broad money allowed to grow so much despite the fact that the real economy was going backwards?
The Bank of England was doing everything it could to stimulate economic recovery. Interest rates were reduced
to near zero, which in itself raised the demand for money, which the Bank was then happy to see supplied.
Although we defer our discussion of inflation until Chapter 22, we are already in a position to sketch an
answer to our third question. If the economy is at full capacity, one might expect a 50 per cent increase in the
broad money supply, and the interest rate reductions that presumably accompanied this, to cause a large rise
in aggregate demand, well above the economy's capacity to supply - a recipe for a surge in inflation.
However, when the economy is facing its sharpest output downturn since the Great Depression, private firms
and households are in no mood to spend. The immediate task is to raise aggregate demand back to acceptable
levels. If and when that is accomplished, confidence will return. The proper task for the central bank is then
to reverse the quantitative easing, reduce the money supply to more normal levels, and raise interest rates to
the levels then required to prevent recovery spilling over into excess demand.
If it is technically possible to inject so much narrow money in such a short time, it is technically possible to
do the reverse - the Bank sells the bonds it has recently acquired and receives narrow money in exchange, which
is then 'retired' from circulation. Narrow money falls, and broad money falls even more as the normal bank
deposit multiplier takes effect.
The key issue concerning financial markets is how the Treasury will then cope. During quantitative easing, it
has been a simple matter to sell government debt to cover the budget deficit - if necessary, the Bank of
England will buy it. Once the Bank is no longer a buyer but now an active seller of government debt, many
private buyers must be found. This could cause a collapse in bond prices or, equivalently, a rise in the interest rates
the government must pay to finance its debt.
In deciding to undertake quantitative easing on such a scale, central banks decided that these possible future
outcomes were the lesser of two evils - without quantitative easing, the severe cutback in bank lending would
have crippled the private sector already.
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