AQA Specification focus:
‘Students should understand current and recent instruments of monetary policy such as: quantitative easing, Funding for Lending and forward guidance.’
Monetary policy instruments shape how central banks influence the wider economy. Understanding tools like quantitative easing (QE), Funding for Lending, and forward guidance is essential for grasping modern macroeconomic policy.
Quantitative Easing (QE)
Quantitative easing is a type of unconventional monetary policy used when interest rates are already very low and cannot be cut further. Instead of lowering rates, the central bank increases the money supply by purchasing financial assets, typically government bonds, from the private sector.
Quantitative easing (QE): A policy where the central bank creates new money electronically to purchase financial assets, thereby increasing liquidity and encouraging lending and investment.
When the Bank of England buys bonds, the sellers (banks and financial institutions) receive cash. This increases the reserves of commercial banks, encouraging them to lend more to businesses and households. By raising demand for bonds, QE also increases bond prices and reduces long-term interest rates, making borrowing cheaper across the economy.
Objectives of QE
Stimulate aggregate demand (AD) by lowering borrowing costs.
Raise inflation towards the government’s target when it risks falling below.
Support growth and employment by providing easier credit conditions.
Potential Problems with QE
Inflation risk if money supply grows faster than output.
Asset price inflation, benefiting wealthier households disproportionately.
Diminishing effectiveness if banks are reluctant to lend.
Funding for Lending Scheme (FLS)
The Funding for Lending Scheme (FLS) was introduced in the UK after the 2008 financial crisis to directly encourage bank lending to households and businesses.
Funding for Lending Scheme (FLS): A monetary policy tool providing commercial banks with cheap funding from the central bank, on the condition that they increase lending to the real economy.
How It Works
Banks and building societies borrow at low cost from the central bank.
The amount of cheap funding available depends on how much the institution expands its lending.
Incentives are built in to favour lending to small and medium-sized enterprises (SMEs), which are vital for growth.
Impacts of FLS
Reduces borrowing costs for firms and households.
Aims to prevent a credit crunch where lending dries up.
Supports investment and consumer spending, stimulating AD.
However, critics argue that:
Lending may still be cautious if banks face high risk or stricter regulations.
Benefits are uneven, with SMEs often struggling to access loans compared to large firms.
Forward Guidance
Forward guidance is a communication tool rather than a direct financial operation. It involves the central bank clearly signalling its future intentions regarding interest rates and monetary policy.
Forward guidance: A policy where the central bank communicates its expected future path of interest rates or other monetary measures, to influence economic behaviour today.
Purposes of Forward Guidance
Manage expectations of households, firms, and investors.
Reduce uncertainty, encouraging borrowing and investment.
Anchor inflation expectations by signalling commitment to the inflation target.
For example, the Bank of England might announce that it intends to keep interest rates low until unemployment falls below a certain level or inflation rises to target. This reassures borrowers and investors that credit will remain cheap in the near term.
Strengths and Weaknesses of Forward Guidance
Strengths:
Inexpensive compared to QE or FLS.
Shapes confidence and stabilises markets.
Can magnify the impact of existing policies.
Weaknesses:
If conditions change, central banks may break their guidance, damaging credibility.
Effectiveness depends heavily on trust in the central bank.
Comparing the Instruments
Similarities
All aim to influence aggregate demand through lending, borrowing, and investment behaviour.
Each supports the inflation target set by the government.
Used when traditional interest rate changes are insufficient, especially at or near the zero lower bound.
Differences
QE works mainly through asset purchases, increasing the money supply and lowering long-term rates.
FLS works directly by incentivising bank lending.
Forward guidance influences behaviour through expectations rather than direct intervention.
Summary Points for Students
QE: Expands the money supply by buying assets, lowers long-term interest rates.
FLS: Provides cheap funding to banks, conditional on increased lending.
Forward guidance: Uses communication to shape expectations of future monetary policy.
These instruments highlight the flexibility of modern central banks in responding to economic shocks.
FAQ
Quantitative easing often leads to a depreciation of the currency. When the central bank increases the money supply and lowers long-term interest rates, domestic assets become less attractive to foreign investors.
This reduces demand for the currency, leading to a weaker exchange rate. A weaker currency can increase exports and boost aggregate demand but may also raise import prices, adding inflationary pressure.
Forward guidance depends heavily on credibility and trust. If households, firms, or investors believe the central bank may change its stance unexpectedly, they may ignore the guidance.
Uncertainty about future economic shocks, such as global recessions or political instability, can also undermine its effectiveness. If people think the central bank lacks commitment, guidance loses impact.
While designed to increase credit, FLS can create risks:
Banks may direct cheap funding to safer lending, such as mortgages, instead of businesses.
If banks lend excessively, it may fuel asset bubbles, especially in housing.
The scheme could distort market incentives by making banks reliant on central bank funding rather than deposits.
QE can make it easier for governments to borrow. By purchasing government bonds, the central bank increases demand, pushing up bond prices and lowering yields.
This reduces the government’s cost of borrowing. However, critics argue that it can blur the line between monetary and fiscal policy, raising concerns about central bank independence.
High levels of uncertainty can weaken the impact of QE, FLS, and forward guidance.
In uncertain times, banks may still avoid lending despite cheap funding.
Firms may postpone investment even if borrowing costs are low.
Households may save rather than spend, reducing the stimulus effect.
Thus, the success of these instruments depends on confidence as well as technical policy design.
Practice Questions
Define forward guidance and explain its purpose in monetary policy. (2 marks)
1 mark for correct definition: forward guidance is when a central bank communicates its expected future path of interest rates or monetary measures.
1 mark for purpose: to influence current economic behaviour by shaping expectations of households, firms, and investors.
Explain how quantitative easing (QE) and the Funding for Lending Scheme (FLS) differ in the way they aim to stimulate aggregate demand in the UK economy. (6 marks)
Up to 2 marks for explaining QE: asset purchases by the central bank, injecting liquidity, raising bond prices, lowering long-term interest rates.
Up to 2 marks for explaining FLS: cheap funding provided to banks, conditional on increased lending to households and businesses, especially SMEs.
Up to 2 marks for comparison: QE works indirectly through financial markets, whereas FLS targets bank lending directly; both aim to stimulate aggregate demand but through different channels.
