Quantitative easing is a posh way of describing the practice of pumping money into the economy to encourage banks to lend.

The hope is that if governments print money, and inject it into the economy, people and companies will be more likely to spend. If they are more likely to spend, there is a greater chance that the economy will spring into life.

Take a bar-room illustration: the bloke at the bar with a fistful of dollars is more likely to splash out on a round than the man who is down to his is last nickels and dimes. Even if the cash is borrowed, it is hoped that greater quantities of cash will breed greater generosity.

How does quantitative easing happen? A central Bank - such as the Bank of England or the US Federal Reserve - buys its own government-issued bonds, such as gilts, or bonds issued by companies or other assets.

As with any purchase, the central bank gives money to the sellers, many of which will be commercial banks. Commercial banks, with their accounts electronically credited by central banks, will then (hopefully) have the confidence to increase lending to customers as well as each other.

The term “printing money” is often bandied around in relation to quantitative easing. The practice of quantitative easing can be broken down into seven stages:

1) The Bank creates new money electronically in its accounts.

2) The Bank buys bonds (companies’ IOUs) and gilts (Government IOUs) from commercial banks.

3) The value of the bonds and gilts bought is now credited to banks that sold them.

4) The commercial banks can make new loans against the increased funding.

5) Extra lending boosts cash and credit flowing in the economy.

6) Extra demand for bonds and gilts from the Bank drives down interest rates for business and consumer borrowers.

7) Flows of extra and cheaper money stimulate growth

Government, or its agents in central banks, can also replace poor-quality money in the economy with good money. Old IOUs issued by companies that may welsh on promises to pay up are replaced with IOUs underwritten by the full force of the state, and its ability to raise tax revenues. This is also like printing money because the old IOUs become useless as a means of exchange.

Replacement, in other words, is akin to creating new money. And by boosting confidence some forms of money (that is, corporate IOUs and the like), it is hoped that confidence across the economy will rise.

While it may be a necessary emergency measure, the danger is that is quantitative easing leads to runaway inflation. And runaway inflation reduces wealth alarmingly.

Explore Economics

• Pre-Budget Report 2009

• Budget 2009

• World Economic Forum

• The Times MPC

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