In the same way that individuals and companies settle transactions using accounts at commercial banks, banks themselves have accounts at the central bank that they use for clearing purposes. Quantitative easing – or tightening – refers to central bank actions that expand or contract the supply of funds held in these reserve accounts.

In operating monetary policy, central banks can alter either the price of money – interest rates – or the quantity of reserves. In recent years interest rate changes have been the dominant tool but historically policy-makers also used quantitative actions to achieve their goals.

A cut in interest rates boosts the economy by stimulating spending and borrowing. Higher bank borrowing results in an expansion in the amount of money in individuals’ and firms’ bank accounts – the broad money supply. This monetary expansion leads to further increases in spending and economic activity.

With quantitative easing, the central bank buys securities from the private sector and pays for them by crediting banks’ reserve accounts – effectively creating new reserves by the click of a mouse. This can boost the economy in two ways. First, if the central bank buys from individuals or firms, the money in their accounts with commercial banks increases, matching the rise in the banks’ reserves with the central bank. This increase in the broad money supply then encourages higher spending.

Secondly, the higher level of reserves may encourage commercial banks to lend more. The higher lending may be associated with a rise in spending and results in a further expansion of the broad money supply, with additional stimulative effects.

Quantitative easing is appropriate currently because interest rates are already exceptionally low and cuts may fail to stimulate borrowing and spending because individuals and firms wish to reduce their debt. A clear sign that interest rates are providing insufficient stimulus is the low rate of growth of the broad money supply.

Quantitative easing is capable of directly boosting money supply growth to the level required to generate an economic recovery. To ensure the necessary impact, however, it is important that the central bank purchases securities from companies and families rather than banks. Buying from banks boosts the broad money supply only if the higher level of reserves causes them to expand their lending. In current circumstances, with banks constrained by lack of capital and potential borrowers reluctant to increase their debt, any such effect might be small.

The annual growth rate of the broad money supply, M4, adjusted for distortions caused by the financial crisis, is currently about 4%. A rise towards 10% is probably necessary to generate an economic recovery. To achieve a boost on this scale, the Bank of England may need to buy £125 billion or more of securities. In order to implement the scheme quickly while minimising distortions to market prices, the Bank should concentrate purchases in gilts rather than corporate bonds or other private sector paper. Statistical work suggests that a programme on this scale could boost gross domestic product (GDP) by more than 1% after a year.

Could quantitative easing lead to an upsurge in inflation? Not so long as policy-makers ensure that the monetary boost is temporary. Once recovery is established, broad money supply growth will need to be reined back to about 6-7% per annum to ensure consistency with the 2% inflation target over the medium term.