Discuss the use of quantitative easing in preventing deflation

Edexcel A-Level Economics Paper 2 June 2024 Extract

With reference to Extract B, discuss the use of quantitative easing in preventing deflation. (12 marks)

Quantitative easing can be useful in preventing deflation as it can promote economic growth. As money supply increases, high street interest rates fall. This means a lower cost of borrowing and lower reward for saving which incentivises more consumers and businesses to take out loans. For example, consumers are more likely to take advantage of lower interest rates by taking out a mortgage. This leads to more demand for houses and therefore an increase in house prices. This leads to homeowners enjoying higher levels of wealth, which boosts consumer confidence. Then consumer spending increases which causes aggregate demand to increase, which leads to an increase in the price level.

Quantitative easing is especially useful as it can be used to prevent deflation even when traditional monetary policy fails. It involves the central bank creating money electronically, and using this to buy assets such as bonds from high street banks. Extract B mentions buying £200bn of government bonds. This gives banks a huge boost in liquidity. As high street banks are profit maximisers, they become be willing and able to lend more money. Therefore, quantitative easing can lead to lower high street interest rates, which again leads to an increase in borrowing, causing aggregate demand to increase, causing an increase in the price level.

However, quantitative easing alone may fail to prevent deflation. This can happen in the case of a liquidity trap, which is when lower interest rates actually fail to stimulate economic growth. This can happen for two main reasons. Firstly, consumer confidence and job security may be low, which means that consumers are likely to continue to save, despite lower rewards for savings, as they must smooth their consumption in case of a future job loss. The extract mentions a freeze on income taxes and the threat of 'deflation' and 'a deep recession'.

Also, the government should consider the impact of their spending and taxes on the economy. Extract A mentions a freeze on income tax thresholds which is now extended to at least 2031. This reduces people's real incomes and therefore reduces consumer spending, so it can cause aggregate demand to fall. This would go against the aims of quantitative easing and would make it harder to prevent deflation.

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