Quantitative Easing – part 2

Imagine a bank that looks like this (simplified for my benefit as much as anything else!):

It has £100,000 of money on deposit. According to banking rules, each bank is allowed to loan out 90% of the money it holds on deposit. Or to put it another way it must keep 10% of the money it holds as customer deposits in cash reserves. Most people don’t need their money as cold hard cash but banks keep this amount for those that do. The rest can be given out to loan customers (at an interest rate of course).

The bank also may own other assets such as Government bonds or property. It cannot loan a percentage of these assets though they make up the accounts of the bank.

Quantitative easing to my knowledge purchases these assets from the banks for cash. The Bank of England twists a few dials in its big Computer Cash machine creating for itself, say £50,000 extra cash. It passes this £50,000 to Bank A in exchange for £50,000 worth of its assets.

The Bank of England now own the assets and Bank A now has £50,000 more of cash reserves. This means if it wants, under the 90% cash reserves rule – it only needs to hold 10% of this (£5,000), the rest it can loan out to you and I for car loans, mortgages or a wee wad of cash to get that Llama farm started you always thought of. The amount of cash in the economy should then increase by £45,000 through the purchases made by those taking out the loans. But better than that, imagine if this £45,000 goes directly to you when someone purchases that 1 bedroom flat you have just sold.

Assuming you are already living somewhere else and decide not to pay off the mortgage that money will probably end up in Bank B or Bank C (as an independent financial adviser I go for Bank B). This new bank on receipt of your deposits can now do what Bank A has done with its extra cash… it can loan out 90% of the £45,000 you just gave it as a deposit. 90% x £45,000 = £40,500 money available to be loaned out from this new bank deposit to some other friend of yours to purchase their first gold laminated dustbin or to set up an ethical business in the developing world. (Money is just the opportunity, it has no taste or ethics of its own). Can you see how the picture develops ? The money supply “expands”

However.

The banks may not decide to loan out the cash. It remains only a potential increase in the amount of cash swilling around. The bank could just hold it in its reserves. This is the risk, this is the experiment.

Vox O’Malley – also a Financial Adviser HERE and developing an ethical investment site HERE