Econ
Robert Nutter Watford Grammar School for Girls
October 2013
How does quantitative easing affect the exchange rate?
Although A level specifications have not changed for some years the introduction of quantitative easing (QE) programmes by central banks such as the Bank of England and the Federal Reserve in the US has meant that A level students have had to become familiar with it as an instrument of monetary policy. With short term interest rates almost at zero and banks still very risk averse, the monetary authorities have in recent years embarked on QE in an attempt to inject liquidity into the financial system to boost lending in recession hit economies.
Although evidence of the success or otherwise of
QE is fairly thin on the ground it is worth considering the effect of QE in other areas of the economy other than investment, inflation and growth. For example how does QE affect the exchange rate of a country? Ceteris paribus, if a country engages in QE, this will normally lead to a depreciation of its exchange rate.
It is possible that QE will increase the money supply and via the quantity theory of money (MV=PT) lead to a rise in inflation. Speculators believing that this will happen then sell domestic currency thus causing the currency to depreciate.
It is true that as yet QE has not caused significant increases in the money supply nor inflation, but that does not stop speculation about higher future inflation. In the UK the broad measure of money supply M4 has, despite QE, been falling not rising in recent years. Thus is the threat of inflation only part of the explanation of the link between QE and the exchange rate? Is there another possible explanation?
A key issue with QE is the effect it has on bond yields, which usually means 10 year government debt (gilt-edged securities in the UK). When carrying out QE a central bank goes into the markets to buy long term government or corporate debt. Bonds, shares and
October 2013
How does quantitative easing affect the exchange rate?
Although A level specifications have not changed for some years the introduction of quantitative easing (QE) programmes by central banks such as the Bank of England and the Federal Reserve in the US has meant that A level students have had to become familiar with it as an instrument of monetary policy. With short term interest rates almost at zero and banks still very risk averse, the monetary authorities have in recent years embarked on QE in an attempt to inject liquidity into the financial system to boost lending in recession hit economies.
Although evidence of the success or otherwise of
QE is fairly thin on the ground it is worth considering the effect of QE in other areas of the economy other than investment, inflation and growth. For example how does QE affect the exchange rate of a country? Ceteris paribus, if a country engages in QE, this will normally lead to a depreciation of its exchange rate.
It is possible that QE will increase the money supply and via the quantity theory of money (MV=PT) lead to a rise in inflation. Speculators believing that this will happen then sell domestic currency thus causing the currency to depreciate.
It is true that as yet QE has not caused significant increases in the money supply nor inflation, but that does not stop speculation about higher future inflation. In the UK the broad measure of money supply M4 has, despite QE, been falling not rising in recent years. Thus is the threat of inflation only part of the explanation of the link between QE and the exchange rate? Is there another possible explanation?
A key issue with QE is the effect it has on bond yields, which usually means 10 year government debt (gilt-edged securities in the UK). When carrying out QE a central bank goes into the markets to buy long term government or corporate debt. Bonds, shares and