It also suggests that, rather than just their size, a more accurate measure of the impact of asset purchases is what they do to bond yields. Combined, and by design, the dual shifts in Chart 9 would leave those yields unchanged. This conclusion is all the stronger once you recognise – as seems to be the case in the data – that the MD line is subject to shifts not just to its position but also in its slope. The effects on bond yields of a given quantum of asset purchases appear to vary. In particular, it seems to be exactly during these episodes of acute market illiquidity – the three I singled out are circled in Chart 10 – that these purchases seem to have been the most effective at tempering any rise in yields. Page 19  Chart 10: Asset purchases seem to have larger effects when markets are illiquid  Sources: Bloomberg Finance L.P, Refinitiv Eikon, Reuters and Bank of England calculations. Chart shows the change in 525 year gilt yields, averaged across maturities, over two-day windows around announcements (see Joyce et al (2011)  ),  except when there are confounding events within this window. October 2011, February 2012, and March 2020 use a narrower window, as MPC announcements coincided with other central bank announcements or major political news. Purchase surprise is the change in the expected target stock of QE purchases among market participants surveyed by Reuters (QE1–QE4) and market intelligence (QE5).
It slopes downwards because – all else equal – the willingness of the private sector to hold reserves is meant to decline as the yield on competing assets like bonds goes up. And when the central bank buys bonds, paying for them with newly-created reserves (shifting the Ms line to the right), their yields therefore decline. In “equilibrium”, for those extra reserves to be willingly held, the competing assets have to become relatively less attractive – hence the decline in yields. Another, perhaps more intuitive, way to think about the effect is that purchasing government bonds directly raises their price (this is the same as a decline in yields). Monetary expansions of this sort therefore raise the supply of central bank reserves, simultaneously lower the level of interest rates and bond yields and, depending on the slope of the “IS” curve, boost demand and subsequently inflation[6]. Page 12  Chart 7: Open-market asset purchases by the central bank raise the supply of reserves and push down interest rates  ‘M’ is real money balances and ‘r’ the real interest rate. This model describes the equilibrium in the money market between supply of and demand for money balances, according to Keynes’ theory of liquidity preference. It underpins the LM curve. The IS-LM model can be a useful way of thinking about monetary policy, and in particular QE. Chart 7 does have its drawbacks, however, or at least some important oversimplifications.