  A second way we can use the balance sheet in support of monetary stability is by using reserves to buy or sell other financial assets in the open market; that lets us directly influence market interest rates. If we buy government bonds, for instance, the price of those bonds goes up which makes their yield – the effective interest rate earned by holders of bonds – come down. Like reserves, government bonds play an important role as safe assets in the financial system, and so changes in their yields also affect broader financial conditions, aggregate demand and inflation. It is this process of using reserves to buy other assets that goes by the complex-sounding and in my view slightly misleading name “quantitative easing” or QE. With Bank Rate having been close to its effective lower bound since the Global Financial Crisis, the “new normal” has been for QE to be the primary monetary policy tool. 8 As Peter put it in a paper with Colin Ellis titled “quantitative easing is not as unconventional as it seems” – it is just another way of using our balance sheet as a tool for monetary stability.9    A third way our balance sheet can be used in support of monetary stability is by lending reserves directly to banks. The precise facilities used to do this vary, with different incentive structures supporting different policy goals.
By potential output and potential growth we mean instead the output and growth that is possible without serious imbalances arising in the economy; the level of output at which supply and demand correspond and actual and expected inflation are in line with the central bank’s inflation target (assuming that there is one). The potential output level is not constant over time; it usually shows a growth trend, which is illustrated in Figure 1. This is mainly because technological developments mean that higher output can be achieved with the same amount of factors of production. Another reason could be long-term changes in the factors of production. The change in potential output from year to year is equal to the potential growth of the economy, which thus is the growth rate that is sustainable in the long term. Figure 1 shows the potential output level according to a simple statistical method where the trend, and thereby also the potential growth rate, is allowed to vary over time. The difference between actual and potential output is known as the output gap, and this reflects the cyclical variations in the economy. A negative output gap, that is to say, when actual output is lower than potential output, is usually connected with a recession. The demand pressure for goods, services and the factors of production is then small and there are ample unutilised resources in the economy. Price and wage increases are small and inflation is usually below the central bank’s target level.