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Explain how the process of quantitative easing in the UK might increase the rate of inflation. (15 marks).

Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.

The Central Bank purchases bonds from commercial banks which it turns from an illiquid state to a liquid state by selling it on to increase the money supply. The Fisher equation is where MV=PT, where M is the money supply, so if there is an increase in the money supply this will inevitably lead to inflation to occur, if the money supply is greater than real output. Inflation happens to be the persistent increase in general price levels with the target level of the UK economy being 2% (plus or minus 1%), which is achieved by manipulating interest rates.

If the economy is growing at a strong rate and there is an increase in the money supply, then financial institutes may be inclined to lend more or to reducing lending rates. This means that people will happen to borrow more as they are able to borrow more money at a lower interest rate so will be able to pay back the money easier than if there was a high interest rate. This means that consumer confidence will increase as they can see that the economy is stable and they are able to borrow more money than previously at a cheaper rate.

As consumers have increased confidence this means that there will be an increase in consumption, and as consumption is a key component of aggregate demand, this will result to demand pull inflation when aggregate demand is increasing at a faster rate than that of aggregate supply. As the diagram illustrates, AD curve shifts to the right from AD1 to AD2 as there has been an increase in consumption

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