9 February 2012 Last updated at 07:06 ET

Q&A: Quantitative easing

How to create money out of nothing - quantitative easing explained

UK interest rates are currently at 0.5% - the lowest level in the Bank of England's history.

The dramatic series of cuts was aimed at easing the credit crunch and getting the banks to lend again.

But that did not happen, at least not to the extent that the Bank thought was necessary to revive consumer spending and economic growth.

So the Bank injected £75bn into the economy in March 2009 through a process known as "quantitative easing" and expanded the programme to £200bn later that year.

In October 2011, the Bank announced a further £75bn of quantitative easing, and it extended the programme again in February 2012 by £50bn, taking the total size of the programme to £325bn.

What is quantitative easing?

Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates.

Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank's only option is to pump money into the economy directly. That is quantitative easing (QE).

The way the central bank does this is by buying assets - usually financial assets such as government and corporate bonds - using money it has simply created out of thin air.

The institutions selling those assets (either commercial banks or other financial businesses such as insurance companies) will then have "new" money in their accounts, which then boosts the money supply.

QE had never been tried before in the UK.

Is this printing money?

These days the Bank doesn't have to literally print money - it is all done electronically.

However, economists would still argue that QE is the same principle as printing money as it is a deliberate expansion of the central bank's balance sheet and the monetary base.

How does it work?

The Bank has been conducting reverse auctions for government bonds, in which the sellers compete in order to drive down prices.

The action by the Bank is supposed to have two effects. The first channel is through the direct effect on the banks' bank accounts. With more money sloshing about in their accounts, the banks may decide to lend more to businesses and individuals, and increase the amount of activity in the economy that way.

The second channel is through the effect on the cost of borrowing. When the Bank buys bonds, it reduces the supply of those bonds in the economy. That should increase the demand for new bonds and, at the same time, make it cheaper for businesses to borrow.

Having taken short-term interest rates as low as possible, the idea would be for the Bank to push down longer-term rates as well, which are the rates that companies and individuals borrow at. These are used by companies making longer-term investments and banks setting mortgages, for example.

In theory if QE works, credit growth should pick up and businesses should find it easier to get credit. That, in turn, should help to stimulate the economy.

Quantitative Easing: Step by step

First, with the permission of the Treasury, the Bank of England creates lots of money. It does this by just crediting its own bank account.

The Bank of England wants to use that cash to increase spending and boost the economy so it spends it, mainly on buying government bonds from financial firms such as banks, insurance companies and pension funds.

The Bank buying bonds makes them more expensive, so they are a less attractive investment. That means companies that have sold bonds may use the proceeds to invest in other companies or lend to individuals.

If banks, pension funds and insurance companies are more enthusiastic about lending to companies and individuals, the interest rates they charge should fall, so more money is spent and the economy is boosted.

Theoretically, when the economy has recovered, the Bank of England sells the bonds it has bought and destroys the cash it receives. That means in the long term there has been no extra cash created.

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Has it worked so far?

A Bank of England report into the effect of the first round of QE suggested that the measure had helped to increase gross domestic product by between 1.5% and 2%, indicating that the effects of the programme had been "economically significant".

Some analysts argue that lending to businesses and individuals remains sluggish, and one of the key aims of QE was to boost lending.

But others argue that it has helped the financial markets by keeping down the interest rate on government bonds.

The simple fact is, no one knows how bad things would have been without QE.

As BBC economics editor Stephanie Flanders says: "Quantitative easing may well have saved the economy from a credit-led depression. We will never know."

Why are the UK's actions different from 1920s Germany and Zimbabwe?

Printing money can be defined as the central bank financing of government debts. This is what happened in both 1920s Germany and Zimbabwe and what the British government will insist it is not doing, although the short-term effect is similar.

According to the Maastricht Treaty, EU member states are not allowed to finance their public deficits by printing money. That is one reason why the Bank of England will buy government bonds from financial institutions, not directly from the government.

The Bank believes this form of QE is different because it is "printing money" as part of monetary policy - to prevent deflation. It is not printing money to help the government finance its deficit.

Also, unlike Zimbabwe, this is a temporary policy: the Bank expects to sell the government bonds back into the market when the economy recovers.