Exchange Rates: Impact of QE on the value of a currency

In this revision topic video we build an answer to a question examining the possible impact of an expansion of quantitative easing (QE) on the external value of a currency.

Question:

Examine the possible impact of an expansion of quantitative easing on the external value of a country’s currency.

Quantitative easing involves a central bank purchasing government bonds from commercial banks and other financial institutions. In return, the banks receive an injection of cash or liquidity onto theirbalance sheets. An increase in QE represents an expansionary monetary policy designed to increase GDP growth and perhaps prevent price deflation.

As a result of increased QE in the bond market we might see an increased demand for bonds which then increases their prices. Since bond prices and yields are inversely–related, QE can lead to a fall in bond yields and long-term interest rates more generally. If interest rates fall, this might then lead to an outflow of “hot money” as investors switch their funds into other currencies offering a higher return.

In this way, QE could lead to an outward shift in the supply of a currency in the foreign exchange markets, which (ceteris paribus) could then lead to a depreciation (fall) of the external value of a currency. Some of glut of extra cash inside the commercial banks might also be lent out externally to other countries which puts downward pressure on the value of a currency.

Evaluation points:

1. QE increases bond prices – this might attract financial inflows into a country (and thereby increase currency demand) as investors seek capital gain
2. QE usually leads to lower interest rates and therefore higher share prices. Positive expectations for rising share values could again attracts inflows of short-term financial capital into a country
3. There is no guarantee that commercial banks will increase lending if there is an increase in QE – the impact on AD/inflationary pressures might be muted which will limit any direct effect on the currency