Introduction: What Central Banks Do When They Run Out of Room
The standard tool of monetary policy is the short-term interest rate. When the economy is weak, cut it. When inflation threatens, raise it.
In late 2008 this tool broke. Policy rates in the United States, the United Kingdom, the euro area and Japan approached zero. The economy needed more stimulus. There was nothing left to cut. Central banks had hit the zero lower bound.
What followed — the large-scale purchase of long-term government bonds and other assets, financed by newly created central bank reserves — was the largest monetary experiment in history. Fifteen years later, we have enough evidence to say what quantitative easing did, what it did not do, and why almost every confident prediction made about it in 2009 was wrong.
1. Why Interest Rates Cannot Go Far Below Zero
Physical currency pays a nominal return of exactly zero. If a bank charges you −5% to hold deposits, you withdraw cash and store it in a vault. Cash therefore imposes a floor on nominal interest rates.
The floor is not exactly zero, because storing, insuring and transporting cash is costly. The effective lower bound is slightly negative — the ECB, the Bank of Japan and the Swiss National Bank all pushed policy rates below zero without triggering mass cash hoarding. But it is not far below zero, and the room is measured in tens of basis points, not percentage points.
The problem this creates is that the real interest rate is what matters for spending decisions:
r = i − πe
If the nominal rate i is stuck at zero and expected inflation πe falls, the real rate rises — automatically tightening policy in a recession, exactly when you need the opposite. This is the mechanism of a deflationary spiral, and it is the reason central banks fear deflation far more than modest inflation.
2. What Quantitative Easing Actually Is
QE is the purchase of longer-maturity assets by the central bank, paid for by crediting commercial banks’ reserve accounts.
Two clarifications that dispose of most public confusion:
QE is not “printing money” in the sense people mean. The central bank creates reserves — deposits held at the central bank by commercial banks. Reserves are not currency in circulation, and households cannot spend them. Whether they translate into broad money depends on whether banks lend, which is a decision banks make, not the central bank.
QE is an asset swap. The private sector gives up a bond and receives a reserve deposit. Its total wealth is unchanged. What changes is the composition of the assets it holds — specifically, the duration and liquidity of those assets. If assets are perfect substitutes, this swap does nothing at all. QE only works because they are not.
3. The Transmission Channels
(a) Portfolio balance / duration risk channel
The central bank removes long-duration bonds from private hands. Investors, wanting to restore their preferred duration exposure, bid up the prices of remaining long-duration assets — corporate bonds, mortgage-backed securities, equities. Yields fall across the curve. This is the primary channel in most models, and it rests on preferred habitat theory (Vayanos and Vila, 2021, Econometrica): different investors have structural preferences for different maturities and cannot costlessly substitute.
(b) Signalling channel
Buying long bonds commits the central bank. If it were to raise rates sharply, it would incur capital losses on its own portfolio. QE therefore serves as a credible signal that policy rates will stay low for longer than markets otherwise expect. Krishnamurthy and Vissing-Jorgensen (2011), in the Brookings Papers on Economic Activity, decomposed the effects of QE1 and QE2 and found the signalling channel accounted for a substantial share of the yield decline — arguably more than the portfolio channel.
(c) Liquidity channel
In a market panic, buyers vanish and liquidity premia spike. Central bank purchases restore a buyer of last resort. This channel dominated in March 2020 and in 2008–09, and it is why the initial rounds of QE had markedly larger announcement effects than later rounds conducted in calm markets.
(d) Exchange rate channel
Lower domestic yields reduce the currency’s attractiveness. Depreciation raises net exports. This channel operates at the expense of trading partners, which is why QE was described in 2010 by Brazil’s finance minister as a currency war.
(e) Bank lending channel
Banks holding abundant reserves might lend more. Empirically, this channel underperformed badly. Reserves accumulated on bank balance sheets. Post-crisis capital and liquidity regulation, weak loan demand, and impaired borrower balance sheets meant that reserve creation did not translate proportionally into credit creation.
4. The Evidence: Did QE Work?
Effects on asset prices
Here the evidence is strong and uncontested. Event studies around QE announcements consistently find substantial declines in long-term yields.
Gagnon, Raskin, Remache and Sack (2011) examined the Federal Reserve’s first programme and found that announcements produced economically large reductions in ten-year Treasury yields, with effects transmitting to agency and corporate debt.
Krishnamurthy and Vissing-Jorgensen (2011) decomposed these effects across channels and made a further point of great practical importance: the effects were asset-specific. Purchasing mortgage-backed securities reduced mortgage rates substantially more than it reduced corporate borrowing costs. This is inconsistent with a pure portfolio-rebalancing story and supports strong market segmentation. It also implies that what a central bank buys matters, not just how much — a conclusion with significant distributional consequences.
Effects on the real economy
Here the evidence is far weaker, because we lack a counterfactual. We cannot observe the economy without QE.
Weale and Wieladek (2016), in the Journal of Monetary Economics, estimated the macroeconomic effects of QE in the US and UK using structural VARs. They found that asset purchase announcements equal to 1% of GDP raised real GDP and CPI by economically meaningful amounts, with wide confidence bands.
Fabo, Jančoková, Kempf and Pástor (2021), in the Journal of Monetary Economics, contributed a finding that should temper confidence in all of the above. Examining the population of studies assessing QE’s macroeconomic effects, they found that papers written by central bank researchers reported systematically larger and more favourable estimates than papers written by academics, and that central bank authors who reported stronger QE effects experienced better career outcomes within their institutions. This is not an accusation of dishonesty; it is a documented pattern of institutional incentive shaping a literature. Students should treat it as a case study in the sociology of empirical economics.
The predictions that failed
In November 2010, a group of prominent economists published an open letter warning that the Federal Reserve’s second round of QE risked currency debasement and inflation. Over the following decade, US inflation persistently undershot the Fed’s 2% target. Japan pursued QE more aggressively and for longer than any other country and struggled with deflation throughout.
The error was in treating reserves as equivalent to money. The quantity theory relation MV = PY does not deliver inflation from reserve creation if V collapses — and at the zero lower bound, with reserves paying interest and banks unwilling to lend, velocity collapsed precisely in proportion to the base expansion.
Yet the inflation of 2021–2023 arrived. Was that QE? The evidence points overwhelmingly to a combination of pandemic supply-chain disruption, energy shocks following the invasion of Ukraine, and fiscal transfers directly to households — money that entered the spending stream rather than sitting in reserve accounts. The distinction between central bank reserves and household purchasing power turned out to be the whole story.
5. Case Study: Japan, 2001 to the Present
Japan invented QE in 2001 and has run the longest continuous experiment.
The Bank of Japan’s balance sheet exceeded the size of the entire Japanese economy — a scale no other major central bank has approached. The BoJ purchased not only government bonds but exchange-traded equity funds, becoming a dominant shareholder in the Japanese stock market. In 2016 it adopted yield curve control, committing to hold the ten-year yield within a narrow band and purchasing whatever quantity was required to enforce it.
Yield curve control is a conceptually different instrument. QE targets a quantity of purchases; YCC targets a price (the yield) and lets quantity adjust. The Weitzman prices-versus-quantities logic applies directly. YCC’s advantage is that if the commitment is credible, the central bank may need to purchase very little — the market enforces the target. Its danger is that if the commitment is doubted, the bank must buy without limit.
For two decades, Japan’s inflation remained near or below zero despite monetary expansion without precedent. The lesson is stark: a central bank can control the monetary base absolutely and still fail to control the price level. This observation has done more damage to naive monetarism than any theoretical argument.
6. The Costs and the Exit
Distributional effects
QE raises asset prices. Assets are held disproportionately by wealthy households. The Bank of England’s own analysis has acknowledged that QE raised wealth inequality through this channel, while arguing that the employment gains from a stronger economy disproportionately benefited lower-income households. Both claims are probably true, and the net effect depends on weights that economics cannot supply.
Fiscal-monetary entanglement
A central bank holding a large fraction of government debt earns interest on it and remits profits to the treasury. When policy rates rise, the central bank must pay interest on the reserves it created — while the bonds it holds pay the old, lower coupon. It runs a loss, and remittances to the treasury reverse.
This materialised across 2022–2024 as policy rates rose sharply. Several central banks, including the Bank of England, moved into loss positions requiring indemnification from finance ministries. The consequence is that QE transformed a portion of long-term fixed-rate government debt into overnight floating-rate debt — shortening the effective maturity of the consolidated public balance sheet and increasing the sensitivity of public finances to interest rates. This is a real cost, and it was almost entirely absent from the 2009 debate.
Quantitative tightening
Unwinding is not symmetric with easing. QE was deployed into panicked, illiquid markets where its liquidity effect was enormous. QT is conducted into calm markets, where the same balance sheet change has a much smaller effect. Furthermore, the level of reserves at which money markets cease to function smoothly is not known in advance — as the September 2019 US repo market disruption demonstrated when reserves fell below an unanticipated threshold.
7. Exam Technique
Cambridge A-Level
- Distinguish sharply between the monetary base (reserves + currency) and broad money (deposits). QE expands the former directly and the latter only if banks lend.
- Use MV = PY to explain why base expansion need not be inflationary: V is not constant, and at the ZLB it falls.
- For evaluation: distributional effects, the exit problem, the exchange rate spillover onto trading partners, and the counterfactual problem (we cannot observe the no-QE world).
AP Macroeconomics
- Be able to draw the money market with a horizontal money supply at the ZLB and explain why further increases in MS do not lower i.
- Connect to the AD/AS model: QE aims to shift AD right by lowering long-term rates and raising investment and consumption.
- Know that QE is unconventional monetary policy, used when conventional open market operations have exhausted their effect.
Summary
Quantitative easing lowered long-term interest rates. On this, the evidence is unambiguous. Whether it meaningfully raised output and inflation is much less clear, and the studies claiming it did are systematically correlated with the institutional affiliation of their authors.
What QE definitely did was reveal that a central bank can expand its balance sheet without limit and fail to generate inflation, because the link between reserves and spending runs through banks and households who may simply decline to participate. That single fact overturned a century of monetary orthodoxy, and it is the most important thing a student of monetary economics can take from the last fifteen years.
Exercises for Further Thought
1. Fabo, Jančoková, Kempf and Pástor documented that central bank researchers report systematically more favourable estimates of QE’s macroeconomic effects than academic researchers, and that reporting stronger effects correlates with career advancement within central banks. Suppose you accept this finding entirely. What should you then believe about the true effect of QE on output? Note that the academic estimates are also not obtained from a neutral position — academics may face incentives to publish contrarian findings. Design a procedure for aggregating a literature in which every author has an incentive, and explain whether such a procedure can exist.
Suggested reading: Fabo, B., Jančoková, M., Kempf, E., & Pástor, Ľ. (2021). “Fifty Shades of QE: Comparing Findings of Central Bankers and Academics.” Journal of Monetary Economics, 120, 1–20.
2. Japan expanded its central bank balance sheet to exceed the size of its economy and could not generate 2% inflation for two decades. The United States and euro area expanded theirs substantially in 2020–21 alongside large direct fiscal transfers to households, and inflation exceeded 8%. Construct an account of the difference that does not simply assert that “fiscal policy matters.” Specifically: identify the mechanism by which a transfer to a household raises the price level when a reserve credited to a bank does not, and state what this implies about the meaning of the term “money supply” in the quantity theory.
Suggested reading: Krishnamurthy, A., & Vissing-Jorgensen, A. (2011). “The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy.” Brookings Papers on Economic Activity, Fall 2011, 215–287.
References
- Bernanke, B. S., Reinhart, V. R., & Sack, B. P. (2004). Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment. Brookings Papers on Economic Activity, 2004(2), 1–100.
- Fabo, B., Jančoková, M., Kempf, E., & Pástor, Ľ. (2021). Fifty Shades of QE: Comparing Findings of Central Bankers and Academics. Journal of Monetary Economics, 120, 1–20.
- Gagnon, J., Raskin, M., Remache, J., & Sack, B. (2011). The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases. International Journal of Central Banking, 7(1), 3–43.
- Krishnamurthy, A., & Vissing-Jorgensen, A. (2011). The Effects of Quantitative Easing on Interest Rates. Brookings Papers on Economic Activity, Fall 2011, 215–287.
- Vayanos, D., & Vila, J.-L. (2021). A Preferred-Habitat Model of the Term Structure of Interest Rates. Econometrica, 89(1), 77–112.
- Weale, M., & Wieladek, T. (2016). What Are the Macroeconomic Effects of Asset Purchases? Journal of Monetary Economics, 79, 81–93.
- Woodford, M. (2012). Methods of Policy Accommodation at the Interest-Rate Lower Bound. Proceedings of the Jackson Hole Economic Policy Symposium, Federal Reserve Bank of Kansas City.