Quantitative easing – 25 mark model answer in style of Edexcel Economics A

How do you write a top level answer on quantitative easing?

As one of the toughest topics in Theme 2, Here is a model answer on the effects of quantitative easing.

Exam style question on quantitative easing

Here is the 25 mark question written in the style of Edexcel Economics A.

It contains a short extract, followed by the practice question.

During the Covid-19 pandemic, the Bank of England ratcheted up its quantitative easing bond-buying programme. Assets held by the Bank of England under quantitative easing peaked at £895 billion during this time. Starting in February 2022, the Bank of England started actively unwinding its quantitative easing asset purchases. QE may have helped prevent a more severe downturn, yet critics argue it contributed to above-target inflation and wealth inequality.

Question: Evaluate the effects of quantitative easing. (25 marks)

Essay plan for quantitative easing

Here is an extended essay plan for the quantitative easing 25 mark question:

• KAA point 1:
  • QE leads to higher C and I, so AD rises.
  • Multiplier effect from higher investment leading to even greater consumption.
  • Link to economic growth.
  • Diagram: AS-AD with AD double shift right.
• Evaluation 1: role of MPC and confidence in size of multiplier.
• KAA point 2:
  • QE leads to lower bond yields or interest rates.
  • This leads to currency depreciation via hot money outflows.
  • This increases net exports, AD, growth, employment and inflation.
• Evaluation 2: other countries may implement QE at same time during a global downturn, so no depreciation overall.
• Conclusion:
  • Effect on C and I strongest due to multiple channels; effect on exchange rate weakest due to other countries’ reactions.
  • Importance of permanence and size of QE – possibility of above-target inflation.

Full model answer on quantitative easing

KAA (Knowledge, application, analysis) point 1

Quantitative easing (QE) involves the Bank of England creating digital money and using it to buy government bonds from financial institutions such as high street banks. Under quantitative easing (QE), the Bank of England’s asset purchases reached £895 billion during the Covid-19 pandemic. By buying government bonds from high street banks, these high street banks now have more cash to invest. This boosts investment in corporate bonds and stocks, giving funds to companies who can then invest more in their businesses. This increases investment levels and as I is a component of aggregate demand (AD = C + I + G + X – M), AD shifts right from AD to AD1. This creates a multiplier effect – the initial increase in I leads to an even larger increase in AD. This is because higher investment means more firm spending on goods, increasing revenues and profits for companies that are selling more goods to these firms. Companies, making higher profits, may spend these funds on increasing worker pay. This raises workers’ disposable income, increasing consumption and further boosting AD. This shifts AD right from AD1 to AD2. Overall QE leads to an short-run economic growth, as real GDP rises from Y to Y2.

Evaluation point 1

However this depends on the size of the marginal propensity to consume (MPC). The MPC may be low in the UK economy when there is low consumer confidence. This is because consumers may be worried about the risk of recession, with the UK entering recession at the end of 2023. So consumers may decide to save more. This reduces the size of the multiplier ratio, $$ \frac{1}{1-MPC} $$ so the increase in AD is smaller. So economic growth will not increase as much following QE.

KAA point 2

QE increases the demand for government bonds. This increases the price of government bonds and thus lowers bond interest rates (there is an inverse relationship between price of bonds and their interest rate). Investors then seek assets with higher yields (i.e. rates of return) such as corporate bonds or stocks, boosting demand for these assets and leading to lower yields on these assets. Lower interest rates in the UK relative to rates abroad lead to hot money outflows out of the UK, as investors seek higher returns abroad. This shifts the supply of pounds right from S to S1 as investors sell pounds and buy foreign currency to move their money out of the UK. This also shifts demand for pounds left from D to D1, as fewer investors are willing to buy pounds to move money into the UK, with the lower relative reward for saving in the UK. So the pound depreciates. Indeed QE could explain part of the depreciation of the pound against the US dollar in March 2020 by 10%. This makes exports cheaper and imports dearer. So export demand rises and import demand falls. So net exports rises, AD rises and real GDP rises, leading to economic growth. As labour demand is derived from demand for goods and services, demand for labour rises, leading to higher employment. Higher AD can also increase the inflation rate, moving inflation closer to the 2% inflation target and avoiding the risk of deflation.

Evaluation point 2

However central banks in other countries may also engage in QE at the same tie. For example the US Federal Reserve engaged in QE in response to the 2020 Covid pandemic, with $700 bn extra asset purchased under QE in March 2020. QE in the US may also lead to lower bond interest rates in the US, at the same time as QE reduces bond interest rates in the UK. So the difference between UK and US interest rates may not change following QE in the UK. So there may be no change in demand for £ and supply of £. So a depreciation may not occur, so net exports may not increase.

Conclusion

Overall, quantitative easing is likely to boost aggregate demand, with the strongest effect occurring through higher consumption and investment due to to increased bank lending and higher asset values. The effect on the exchange rate is likely to be small given other countries may also engage in QE if there is a global downturn. The level of QE also matters. If QE becomes permanent and too many assets are purchased under QE, this could contribute to permanently higher inflation above the 2% inflation target. Indeed expansionary monetary policy may have contributed in part to inflation reaching 11.1% in October 2022 in the UK, reducing purchasing power for those on fixed incomes.

Commentary on the answer

The answer achieves all of the criteria for a top level answer:

• Developed chains of reasoning for analysis paragraphs.
• Accurate, high level diagrams.
• Use of real world examples to support the arguments.
• Evaluation points with a mini chain of reasoning in a way that links back to the question on QE.

As a result, this answer is likely to score full marks or close to this.

Regarding the exchange rate diagram, if you have not covered the exchange rate diagram yet, you can still use the same chain of reasoning and secure full marks. The exchange rate diagram is an added bonus for those who have covered theme 4 content on exchange rates.

Other possible points could include, but are not limited to:

• QE leading to rising asset prices and creating a positive wealth effect.
• QE may increase inequality through its effect on asset prices.
• QE, by reducing interest rates on government bonds, makes it cheaper for the government to borrow.
• The importance of the level of spare capacity in the economy in determining the effects of QE on real GDP and the price level. This could include reference to the Keynesian LRAS.

Related Edexcel A Economics A Level resources