Question

Which of these statements is correct? The purpose of quantitative easing is: (a) to create money in order to create inflation and reduce the real value of government debt; (b) to force banks to create deposits despite having inadequate bank reserves; (c) to make the central bank the purchaser of last resort for government bond issues; (d) to prevent a collapse of broad money when banks are unable or unwilling to lend.

Short answer

The correct statement is (d): to prevent a collapse of broad money when banks are unable or unwilling to lend.

Step-by-step solution

Understand Quantitative Easing

Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy becomes ineffective. This involves the central bank purchasing longer-term securities from the open market to increase the money supply and encourage lending and investment.

Evaluate Statement (a)

The purpose of QE is to increase the money supply, which can lead to inflation if managed improperly, potentially reducing the real value of government debt. However, the primary goal is not to create inflation, but to boost economic activity. Therefore, statement (a) is not entirely correct.

Evaluate Statement (b)

While QE can lead banks to create more deposits by changing the reserves in the banking system, it does not force banks to create deposits despite inadequate reserves. Thus, statement (b) is incorrect.

Evaluate Statement (c)

In the process of QE, the central bank may buy government bonds from the market, effectively acting as a purchaser of last resort to ensure these bonds can be sold. Statement (c) captures a possible side effect but is not the main purpose of QE.

Evaluate Statement (d)

QE is indeed aimed at preventing a collapse in the money supply; by purchasing securities, the central bank injects liquidity into the financial system to encourage lending. Statement (d) correctly reflects this aim of QE, making it the correct choice.

Key concepts

Monetary Policy

Monetary policy is a crucial tool used by governments and central banks to regulate the economy. It involves the management of money supply and interest rates to achieve macroeconomic objectives like controlling inflation, consumption, growth, and liquidity. Central banks utilize monetary policies to either increase or decrease the amount of money available in the economy. This is done by manipulating interest rates and other instruments to influence economic activity. For example, lowering interest rates typically encourages borrowing and spending, as loans become cheaper.
Quantitative easing (QE) falls under monetary policy, particularly when conventional policies such as lowering interest rates are no longer effective. By purchasing longer-term securities, a central bank injects liquidity directly into the financial system, increasing the money supply and encouraging banks to lend more. This is often necessary when the economy is stagnating or is in recession, as it can stimulate economic growth by making capital more accessible.

Central Bank

A central bank is the principal authority in a country's monetary system. It is responsible for managing currency, controlling inflation, and overseeing banking systems. Some well-known central banks include the Federal Reserve in the United States, the European Central Bank, and the Bank of England.
Central banks use a variety of tools to maintain economic stability. These include setting benchmark interest rates, regulating foreign exchange, and more recently, implementing quantitative easing programs. The central bank's role is to rotate between restraining inflation and encouraging growth, depending on the economic conditions. By purchasing government bonds and securities, they increase cash flow in the economy, intending to stimulate spending and investment.

• Ensuring stability in the financial system is a core function.
• Regulating other banks to prevent financial crises.
• Being the lender of last resort during times of financial instability.

Through these activities, central banks influence other banks and financial institutions to uphold the stability and efficiency of the financial system.

Economic Stimulus

Economic stimulus refers to policy measures implemented to encourage economic growth or to ward off an economic slowdown. It typically involves government or central bank interventions. Economic stimulus can take several forms, such as fiscal policy changes, tax cuts, or increasing public spending.
In the context of central banking, economic stimulus often involves monetary measures like reducing interest rates or employing quantitative easing. These actions aim to increase spending by consumers and businesses. For instance, when interest rates are lowered, borrowing becomes more attractive for both businesses and individuals, leading to increased consumption and investment.
Quantitative easing, as an economic stimulus, aims to heighten the economic activity by injecting liquidity into the market. By buying financial assets, central banks increase the money supply, which lowers interest rates on loans and encourages increased lending.

• Implemented during economic slowdowns to revive the economy.
• Often tailored to address specific economic challenges.
• Aims to create jobs and boost economic productivity.

Also, a significant goal of economic stimulus is to increase consumer confidence, which encourages spending and investment, further driving economic recovery.