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What is Quantitative Easing and does it cause inflation?

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Quantitative Easing is essentially the creation of money. As we live in a digital age, the money is not even printed any more but simply created on computers. How come we aren’t seeing prices rise?

The money is used to buy assets from banks and other big financial institutions, usually government bonds. The idea is that the banks that hold these bonds are now able to lend this money on to businesses and individuals. This is not what is happening. Banks are mostly hoarding the money that they are getting from selling government bonds in case they have further claims on their reserves.

Money is still getting in the system. Despite unprecedented (at least in living memory) worries about government solvency bond yields are down rather than up as all the money goes almost directly into buying bonds. This has meant that investors are getting tiny amounts of money for putting their money into government bonds, and so putting their money elsewhere. It also means that governments can borrow despite a collapse in the amount of tax they collect, and so keep spending at a very high level.

Is this causing inflation? It really depends what you mean when you say inflation. There are two definitions of inflation. The first is inflation in the sense of a tire being filled with air, it is the process of the air coming (and staying) in rather than the process of the tire rising that is the inflation. So with money. Inflation is simply money coming and staying in the system. By this definition Quantitative Easing is inflation, not a cause of it.

The more common meaning of inflation is that of a general price rise. Prices on their own rise and fall to reflect the factors of supply and demand. Prices in general will neither rise nor fall if the money in the system is the same, and it is going at the same speed. Well the money is definitely not the same, so prices should be rising, but they are not rising, or not as much as they used to when there was much less money being poured into the system. The problem is the speed rather than the quantity. The speed is known to economists as velocity. If the velocity is slower then there is in effect less money in the system as it is not being spent. If the money is simply going into bank accounts then it is in effect being withdrawn from the system.

So is Quantitative Easing causing inflation? Some people say that it’s counter balancing deflation as banks would hang on to money just as much as they would have if Quantitative Easing was not in place. If you aren’t seeing enormous inflation, they argue, you are also not seeing enormous deflation. Some also claim that rising prices will happen, just not yet. There’s a wall of money that is sitting on the sidelines. Sure, it’s not around at the moment, but when the velocity picks up then we’ll see it, in shop prices.

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