Quantitative easing (QE) is a common form of unconventional monetary policy that is frequently referred to as money printing – incorrectly. QE does not involve the creation of notes and coins by central banks, which is still only a small portion of overall money supply. If QE is not money printing, then what is its purpose and is it directly inflationary? In this post, I’ll attempt to provide an explanation of what QE is and the process of money creation.

The Myth of the Money Multiplier

It is a very wide misconception that banks simply act as an intermediary lending out deposits made by other savers. In the modern economy, this is simply not true. Lending creates deposits, not the other way around. Private banks are the creators of deposit money and have no limit on their funds available to lend as long as they meet regulatory liquidity requirements. As private institutions, banks decide how much they wish to lend based on the profitability of available lending opportunities. Importantly, there is no money multiplier. The demand for loans from these banks rely heavily on the prevailing interest rate on these loans. While central banks do not control the amount of reserves, they can set the ‘price’ of reserves through interest rates.

The Process of QE:

Central banks’ preferred monetary policy tool is setting the interest rate (bank rate) on bank reserves in the overnight lending market. This should then effect a number of interest rates in the economy, such as bank loans. However, there is very little proof of this tool effecting longer-term interest rates in the economy and central banks run into a problem when the interest rate (bank rate) on these reserves are already near zero, while spending in the economy is not consistent with the central bank’s objective. The most common response is quantitative easing, which is just the central bank purchasing assets (ex: long-term government debt, mortgage backed securities) from mostly the non-bank financial sector (ex: insurance companies, pension funds). Since only commercial banks have reserve accounts at central banks, they are used as an intermediary in this transaction. In effect, when a central bank wishes to buy assets from a pension fund, the pension fund’s bank would credit its account by $x. The central bank would then credit the private bank’s reserve account (w/ equivalent $ amount) to finance the purchase.

As shown by the image above, there is only a change of financial asset composition in the private sector, no new money was printed as a result of QE. The increase in commercial bank reserves at the central bank have no effect as they cannot be lended to consumers within the economy. Since QE initially increases the pension fund’s deposits, the fund is likely to deploy those deposits in higher-yield assets (ex: shares). Some argue that the asset swap performed by QE has little inflationary effect as the new deposits will only be used to buy assets in the financial sector and is not in the hands of consumers. Others argue that as a result of the central bank buying longer-term debt, the yields of these assets should fall along with longer-term interest rates. This then creates a favourable environment for lending to stimulate spending/investment within the economy

In sum, quantitative easing is not money printing, but an asset swap by the central bank to stimulate the economy. The increase of bank reserves does not directly go into the hands of the people in the economy as it is only to be used by actors with reserve accounts at the central bank. Although, central banks have enormous influence over the amount of money in the economy, there is no direct control of the monetary base. The majority of the money in circulation comes from commercial banks as opposed to printed by central banks. When the bank rate in the overnight market does hit its effective lower bound, it is appropriate for the central bank to begin an asset purchase program (QE) in the hopes of raising prices across the economy.

More Reading: https://www.researchaffiliates.com/publications/articles/364_whats_up_quantitative_easing_and_inflation#:~:text=When%20banks%20do%20not%20wish,therefore%20does%20not%20cause%20inflation.
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy