The Impact of Quantitative Easing on the United Kingdom s Economy An Analysis of the Market for Money in the UK

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1 , pp The Impact of Quantitative Easing on the United Kingdom s Economy An Analysis of the Market for Money in the UK Marissa Ooi Sze Min 1 and Jer Lang Hong 2 1 Taylor s University 2 Evault Technologies 1 Introduction On 4 August 2016, the Bank of England s (BoE) monetary policy committee announced a comprehensive package to soften the shock of the European Union (EU) referendum result. The package included quantitative easing (QE) as a measure to tackle downside risk associated with a fragile economic climate arising from the referendum result to exit the EU (Elliot, 2016). In a separate report, Elliot (2016) further highlighted that the BoE s plan to implement QE is well-justified as evidence shows QE positively impacts the economy by lowering long-term borrowing costs, boosting share prices and spurring exports. This paper will analyse the impact of QE on money supply and the targeted interest rate by utilising the money demand (MD)/money supply (MS) model. Additionally, the investment schedule (IS)/liquidity preference-money supply (LM) model and aggregate demand (AD)/aggregate supply (AS) model will be used to illustrate the impact of the BoE s QE on the United Kingdom s (UK) real gross domestic product (GDP). 2 Definitions Open Market Operations (OMO) involve a central bank s sale and purchase of government securities to or from the general public, including commercial banks, using existing money. In contrast, QE concerns central bank s creation of new money electronically to purchase financial assets, mainly long term sovereign bonds, such as government securities and corporate bonds (Bank of England, 2016). QE constitutes expansionary monetary policy which is the policy by which a central bank targets a lower interest rate by expanding money supply to ensure price stability and full employment (Rasiah, Yap and Chenayah, 2014). QE is a high-profile, unconventional form of expansionary monetary policy which has two emphases: to increase monetary base and to reduce long term interest rates. The Federal Reserve (2015) states that monetary base comprises reserve balances and currency in circulation. QE raises banks reserve levels, hence effectively increasing the monetary base. In the case of conventional monetary policy, short term interest rates are affected through open market operations. Miles, Joyce, Scott and Vayanos (2012) emphasise that unlike conventional monetary policy where the fluctuations in volume ISSN: ASTL Copyright 2017 SERSC

2 of reserves are not the primary focus of the policy, QE relies on these fluctuations to attain desired changes in interest rates; in other words, QE injects financial institutions with excess liquidity to encourage lending and thereby stimulate the economy. Bernanke (2014) highlights that QE differs from OMO in that it is used when interest rates near the zero bound, and its scale is larger than OMO to inject substantial liquidity and reduce long-term yields. 2.1 Impact of QE on Money Supply, Interest Rates and Quantity of Money Demanded BoE targeted a lower interest rate (r 2) to stimulate their cautious economy. To achieve r 2, the money supply was increased via QE involving UK corporate bond purchases of up to 10 billion and UK government bonds purchase of 60 billion (Bank of England, 2016). As shown in Table 1, commercial banks reserves rose as they received money from selling bonds held in their portfolio. Upon purchasing government and corporate bond, BoE's securities and reserves increased as displayed in Table 2. To substantiate this, BoE s sterling denominated assets increased by 27,289 million after QE, with a significant rise in loans to Asset Purchase Facility which finances the purchase of securities from commercial banks to improve liquidity in the market; hence, BoE s reserves increased. As evidence, BoE s weekly report dated 2/11/2016 showed that reserves balances and notes in circulation increased by 26,532 million and 1,236 million respectively compared to figures as at 3/8/2016 (Bank of England, 2016). The rise in reserves and notes in circulation increased narrow money (M1) which therefore increased MS. Consequently, the MS 1 curve shifted rightwards to MS 2. With reference to Diagram 1, the money market would be at point b after the rise in money supply. At the initial interest rate (r 1), MS2 exceeded MD. Hence, there was a surplus as indicated in Diagram 1. To eliminate this surplus, interest rates fell to r 2. The interest rate decrease led to a rise in bond prices due to the inverse relationship between the two (Jordan, Westerfield and Ross, 2011). When bond prices rose, expected profits from bonds increased, and people wanted to buy bonds as a store of value. Moreover, the opportunity cost of holding bonds reduced as interest rates fell. This increased the demand for bonds and the quantity demanded for money (for asset demand) rose, causing a rightward movement along the MD curve from point a to point c. Consequently, a new money market equilibrium was achieved at point c, at a lower interest rate of r Impact of Lower Interest Rates (an Implication of QE) on Investment Referring at the IS-LM model illustrated in Diagram 2, the LM curve shifted rightwards to LM 2 due to expansionary monetary policy in the form of QE. At i 1, there was a surplus in the money market. To eliminate this surplus, interest rates fell. Through a chain effect, other interest rates (i) such as the base rate, saving rate and fixed deposit rate dropped. These rates fell because banks' cost of borrowing funds was lowered. As evidence, soon after QE was carried out HSBC, Royal Bank of Scotland and Lloyds Bank revised their interest rates downwards (MacAskill and Cruise, 2016; Treanor and Copyright 2017 SERSC 97

3 Brignall, 2016; Uttley, 2016). Meanwhile, long-term interest rates fell. Savings were discouraged as interest to be earned was relatively lower; investment was stimulated as cost of borrowing fell. Thus a rightward movement along the IS curve from point d to e was observed. The movement from Y 1 to Y f depicts the rise in real GDP contributed by an increase in investment. 2.3 Impact of QE on Real GDP Since investment is a component of AD, higher investment shifted the AD 1 curve in Diagram 3 rightwards to AD 2. At the initial price level P 1, AD 2 exceeded the short-run aggregate supply (SRAS). This shortage drove prices up to P 2. When prices rose, the quantity demanded of goods and services (G&S) fell, indicated by a leftward movement along AD 2 from point g to h. This was caused by the wealth effect, and intertemporal substitution effect and international substitution effect. Meanwhile, assuming fixed wages, higher prices attracted firms to produce more to make more profits. Thus, the quantity supplied of G&S rose, causing a rightward movement along SRAS from point f to h. Consequently, the multiplier effect set in and the UK s economy moved from Y 1 to Y f. With h as the new equilibrium, it is observed that output and price have increased, and the economy returned to full employment, assuming it previously faced a recession gap. 3 Conclusion and Recommendation The BoE used QE as pre-emptive measure to offset the possible further negative effects of the EU referendum result. Krugman (2009) stated that QE is regarded as the required stimulus for economies facing the zero lower bound problem, such as with the case of Japan and the United States. The UK economy s surprising 0.5% growth in the 3 rd quarter beat forecasts and lends credence to QE s effectiveness (Thomas, 2016). However, as the announcement for QE was made in the 3 rd quarter, 4 th quarter GDP figures need to be examined to provide a firmer evaluation of its effects. Moreover, following Ugai s (2006) note that economic issues are multi-faceted, policy measures taken when short term interest rates near the zero bound call for additional studies to distinguish the implications stemming from structural adjustment, QE and the zero bound constraint on interest rates. Inflation should also be monitored to ascertain if the BoE s goal of price stability has been met. It is to be noted that QE is an unconventional form of expansionary monetary policy which can have unprecedented side-effects and may trigger an undesired degree of inflation if sufficient caution is not exercised (BBC, 2016). 98 Copyright 2017 SERSC 3

4 Diagrams and Tables Surplus Diagram 2: IS-LM Model Diagram 1: Money Demand/Money Supply Model Diagram 2: IS-LM Model Shortage Diagram 3: Aggregate Demand/Aggregate Supply Model Table 1. Change in commercial banks balance sheet Commercial Banks Assets Securities Decrease by x Reserves Increase by x Liabilities Copyright 2017 SERSC 99

5 Table 2. Change in commercial banks balance sheet Assets Securities Bank of England Liabilities Reserves Increase by x Increase by x References 1. Bank of England (2016) How Does Monetary Policy Work? Available from: [Accessed 6 November 2016]. 2. Bank of England (2016) Weekly Report: 2 November London: Bank of England. 3. Bank of England (2016) Weekly Report: 3 August London: Bank of England. 4. BBC (2016) What is Quantitative Easing? Available from: [Accessed 13 November 2016]. 5. Bernanke (2014) The Federal Reserve: Looking Back, Looking Forward. Available from: [Accessed 8 November 2016]. 6. Elliot, L. (2016) The fragile UK economy has a chance to abandon failed policies post- Brexit. Available from: [Accessed 13 November 2016]. 7. Elliot, L. (2016) Bank of England Rebuts May and Hague's Attacks on Quantitative Easing. Available from: [Accessed 20 October 2016]. 8. Federal Reserve (2015) What is The Money Supply? Is It Important? Available from: [Accessed 12 November 2016]. 9. Jordan, B. D., Westerfield, R. W. and Ross, S. A. (2011) Corporate Finance Essentials. 7 th ed. United States: McGraw-Hill. 10. Krugman, P. (2009) The Conscience of a Liberal. Available from: [Accessed 12 November2016]. 11. MacAskill, A. and Cruise, S. (2016) HSBC to pass on BoE rate cut to tracker, variable mortgage rate customers. Available from: [Accessed 7 November 2016]. 12. Miles, D., Joyce, M., Scott, A. and Vayanos, D. (2012) Quantitative Easing and Unconventional Monetary Policy-An Introduction. The Economic Journal [online]. 122 (12), pp [Accessed 7 November 2016]. 13. Rasiah, R., Yap, M. M. and Chenayah, S. (2014) Monetary Economics. Selangor: Oxford Fajar. 14. Thomas, N. (2016) UK economy beats forecasts and grows 0.5% in third quarter. Available from: [Accessed 12 November 2016]. 15. Trading Economics (2016) United Kingdom Gross Fixed Capital Formation. Available from: [Accessed 7 November 2016]. 16. Treanor, J. and Brignall, M. (2016) RBS accedes to Bank of England call to pass rate cut to customers. Available from: Copyright 2017 SERSC 5

6 accedes-to-banks-call-to-pass-interest-rate-cut-to-customers [Accessed 14 November 2016]. 17. Ugai, H. (2006) Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses. Tokyo: Bank of Japan. 18. Uttley, H. (2016) Lloyds passes on interest rate cut to limited customer base. Available from: [Accessed 7 November 2016]. Copyright 2017 SERSC 101