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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 can increase 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 quantitative easing, 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.

However, the process of governments issuing bonds, banks buying them and central banks buying the bonds off the banks does increases the money supply. This is because banks buying bonds results in an increase in money supply as shown in part 15, and the central bank buying those bonds replaces the reserves of the bank leaving the bank in the same state it was in prior to it buying the bonds. The new money ends up in the government's bank account.

This process is often referred to as monetising government debt.

back to Part 16

Continue to Part 18:
How banks are bailed out