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Part 17. How quantitative easing works

We saw in Part 14 that when governments issue bonds and banks buy them it increases the money supply. There is an analogue to this called quantitative easing which increases reserves at banks. It works by the central bank buying government bonds off banks.

To demonstrate this, we will go back to our banks and accounts from Part 15, where the two government bonds issued are still in circulation, and get Central Bank to purchase the £20,000 government bond from 2nd Bank. We need to introduce a new account at Central Bank we will simply call Government Bonds. The bond purchase transaction is shown in Figure 17.1

Government Bonds 2nd Bank Description Debits Credits Balance Previous balance £20,000 (DR) Transfered to Central Bank £20,000 £0 Government Bonds Central Bank Description Debits Credits Balance Starting balance £0 Received from 2nd Bank £20,000 £20,000 (DR)

Figure 17.1 Government bond purchase by Central Bank.

And the complementary double entry for this interbank transfer is the reserves double entry as shown in Figure 17.2.

2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £5,000 (CR) Transfer reserves £20,000 £25,000 (CR) Digital Reserves 2nd Bank Description Debits Credits Balance Previous balance £5,000 (DR) Transfer reserves £20,000 £25,000 (DR)

Figure 17.2 Reserves double entry for the bond purchase.

The balance sheets of all banks is shown in Figure 17.3, and as can be seen, 2nd Bank's reserves are now increased by £20,000 — at the expense of its government bond, and Central Bank's assets and liabilities are increased by the same.

Central Bank's Assets Mortgage-backed Securities £50,000 Government Bonds £20,000 Total assets £70,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £25,000 1st Bank's Digital Reserves £45,000 Total liabilities £70,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Mortgage-backed Securities £50,000 Digital Reserves £45,000 Total assets £195,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Government's Deposit Account £40,000 Total liabilities £195,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £25,000 Total assets £75,000 2nd Bank's Liabilities House Seller's Deposit Account £70,000 Deposit Account #4 £5,000 Total liabilities £75,000

Figure 17.3 Balance sheets after the central bank bond purchase.

So, quantitative easing only increases the reserves at banks. It doesn't directly increase the money supply that people and businesses use. As seen previously, reserves facilitate bank lending. However, quantitative easing, doesn't necessarily mean banks will lend more, it just provides the means by which a bank can lend more. It also requires the availability of bonds to purchase.

A government and central bank can work together to expand the money supply in an economy by the government issuing bonds and the central bank buying them. The caveat is that increasing the money supply without increasing the size of the economy can cause inflation or hyperinflation; that is, it can reduce the value of the underlying money and debt.

back to Part 16