QE2: Bank of England announces plans to pump £75bn into economy through quantitative easing

Quantitative easing, often misunderstood as a process of 'printing money' is actually a means of stimulating a struggling financial system by creating a wedge of electronic cash. No notes actually get printed. Think of it as magic money.

In QE2, these billions will be used to buy gilts (gilts are government bonds, no corporate bonds are being issued this time around). Why is this good for the economy? "Some gilts are held by pension funds, insurance funds and other institutional investors," explains LondonLovesBusiness.com's editor-at-large Charles Orton-Jones. "These institutions will then be motivated to invest the money from the sale elsewhere, triggering a rippling effect of transactions through the economy."

What happens to the gilts in the future? Eventually the gilts bought with the QE money will be bought back by the government or sold to the private sector, meaning the Bank of England will get its £275bn back. And what happens then? The Bank will destroy the money it created electronically, a process known as "unwinding".

Will this money ever actually be paid back? Well, we still haven't begun buying back the bonds issued in March 2009, so it will be quite some time until our economy will have the clout to attempt to settle the debt.

The downside of the QE2

Quantitative easing reduces currency value by flooding the system with more cash. It also causes ripples of anxiety across the markets. Nothing says, 'our economy is in the doldrums' like a bout of QE. Sterling fell by almost two cents after the announcement to $1.5280, its lowest since late July 2010.

In theory, QE should encourage more borrowing and investment. But some economists have warned that quantitative easing can lead to very high inflation in the long term.

The Bank of England has released a statement outlining the thinking behind this latest £75bn QE2:

"In the United Kingdom, the path of output has been affected by a number of temporary factors, but the available indicators suggest that the underlying rate of growth has also moderated."

Translation: New data shows that the UK economy grew by just 0.1% between April and June, down from 0.5% growth earlier this year.

"The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term.

"In the light of that shift in the balance of risks, and in order to keep inflation on track to meet the target over the medium term, the committee judged that it was necessary to inject further monetary stimulus into the economy."

Alongside the QE2 announcement, the Bank of England has also held interest rates at the record low of 0.5% for the forseeable future.

Confused by quantitative easing? Unsure of inflation? Let us know and we'll explain further.

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