Quantitative Easing

A purchase settles as a simple swap of assets. The central bank buys a bond from a primary dealer or institutional holder and credits the seller's bank with new reserves; the commercial bank in turn credits the seller's deposit account. The central bank's assets lengthen in duration, its liabilities grow by the same amount in reserve balances, and no physical currency is created.

This distinction matters. Reserves circulate only among banks and the central bank; they are not lent directly to households or firms. Broad money expands only to the extent that bank deposits rise and lending responds. Where banks are capital-constrained, borrowers are deleveraging, or reserves are remunerated at a rate that makes holding them attractive, the textbook money multiplier breaks down and the base expands far faster than broad money or nominal spending.

The portfolio balance channel is the core mechanism. By removing duration and credit risk from private portfolios, the central bank compresses the term premium embedded in long yields and forces investors to rebalance toward remaining risk assets, lifting equity and corporate bond prices and lowering discount rates on real investment. Lower domestic yields typically weaken the currency, supporting exports and imported prices.

A second channel is signalling. Committing to hold a large portfolio of long-dated assets makes an early rate rise costly for the central bank and therefore less likely, which anchors expected short rates. A third, most visible in acute stress, is market functioning: standing ready to buy in size restores liquidity and narrows bid-ask spreads in the sovereign market that prices everything else.

The footprint is observable. Central bank balance sheets are published weekly or monthly, so the pace of purchases, the maturity composition and the split between sovereign, agency and corporate holdings can be tracked directly. Yield curve slope, estimated term premia, mortgage spreads over Treasuries and cross-currency basis all move around announcement dates, and event-study evidence around major programme announcements is the standard way effects are measured.

The macro record is more nuanced. In Japan, the euro area and the United States, large-scale purchases coincided with strong asset price appreciation but subdued consumer price inflation for years, alongside falling money velocity. Candidates should read that as evidence about transmission strength, not as proof that the balance sheet is irrelevant to inflation.

Exit is part of the policy. Tapering slows purchases but keeps the stock rising; quantitative tightening shrinks it, usually by letting maturing securities run off rather than through outright sales. Both have market consequences: the 2013 taper episode showed how a change in expected purchase pace can steepen curves sharply, and the 2019 repo disruption showed that shrinking reserves too far can strain funding markets even without a policy rate change.

At Level I, be able to explain why the policy is reserved for the effective lower bound, trace the transmission from purchase to yields to spending, distinguish base money from broad money, and discuss the limits and costs: distorted risk pricing, distributional effects through asset ownership, impaired market signals and the risk of blurring the line between monetary and fiscal policy.