Quantitative easing as an asset swap

Follow the payment through three balance sheets

An asset swap exchanges one claim for another. To see exactly what changes, extend the purchase above with a separate paper balance sheet. Before the transaction, suppose the investor owns a government bond valued at 50 and a bank deposit of 20, with no debts. Its assets and net worth are both 70. After selling that bond for 50, it owns no bond and a deposit of 70. Subtracting liabilities still gives net worth of 70. The investor can now make a bank payment without first selling a security, but the exchange has not added another 50 to its wealth.

Suppose the investor's bank begins with reserves of 30 and loans of 90. Its assets total 120. Deposits of 100 and equity of 20 finance those assets. The investor's initial deposit of 20 is part of that 100, not an extra liability outside the total. When the central bank settles the purchase, the commercial bank's reserves rise from 30 to 80. Its deposits rise from 100 to 150. Assets are now 170 and liabilities plus equity are also 170. Equity remains 20. A reserve asset worth 50 has arrived, but the bank owes its customer another 50.

The central bank has the third set of entries. It records the purchased bond as an asset of 50 and records an additional reserve liability of 50 to the commercial bank. It has not credited a reserve account owned by the investor. The investor holds a claim on the commercial bank; the commercial bank holds a claim on the central bank. These claims can have different holders and access rules even though both use the same currency unit. The central bank acquires a bond claim on the government, whose promised payments remain outstanding.

Do not add the bank's new reserves to the customer's new deposit and call that investor purchasing power of 100. The investor gained only a deposit of 50 in exchange for its bond. The reserve increase explains how its bank received settlement. Nor should the bond's face value replace its transaction price. If a bond promising 60 at a future date trades for 50 today, the purchase payment in this case is 50. Future payments and today's purchase price refer to different dates. The central bank does not credit reserves equal to face value merely because that number appears on the contract.

These paper balances make the unchanged equity visible rather than assumed. If the bank charged a fee, or the investor sold at a price different from its earlier recorded value, those would require additional entries. Keep such entries separate from settlement. Otherwise an apparent profit from money creation may actually be a fee, a previously unrecognized valuation gain, or a comparison between amounts at different dates.

Compare counterparties before comparing purchase totals

Use the same opening bank balance sheet for a contrasting paper case, but replace 50 of its loans with government bonds worth 50. Its assets are reserves 30, loans 40, and bonds 50, still totaling 120. Deposits are 100 and equity is 20. If the central bank buys those bank-owned bonds for 50, reserves become 80, loans remain 40, and bonds become zero. Total assets remain 120. Deposits remain 100 and equity remains 20. The bank has replaced a security with settlement balances. No customer sold anything, so there is no customer deposit to credit in this transaction.

Compare two purchases of equal size. Both increase central-bank reserve liabilities by 50. A purchase from the nonbank investor increases commercial-bank assets and deposits by 50. A purchase from the bank's portfolio changes the composition of commercial-bank assets without expanding their total. The reserve figure alone cannot distinguish these cases. To interpret a purchase announcement, identify who ultimately sells the asset, not merely which dealer or bank transmits the order. An intermediary can execute a sale for someone else without being the economic owner of the bond.

Consolidation provides another useful comparison. Treat the treasury and central bank as a single public group for this calculation only. A treasury bond held by the investor is initially a public liability to an outside holder. After the purchase, the bond is held within the public group and cancels against the treasury's corresponding obligation on consolidation. The reserve liability of 50 remains owed to a bank outside that group. At the transaction price, one public liability to outsiders has replaced another. Private net financial claims on the consolidated public group have not risen by 50.

Consolidating the private bank and investor also cancels the investor's deposit against the bank's deposit liability. Before the nonbank sale, their external public claim includes the bond of 50. Afterward, it includes the additional reserves of 50. The customer's larger deposit is real and usable, but it is an internal claim within this consolidated private group. Cancellation for a particular question does not mean that an individual depositor's legal claim is unimportant or that a bank can ignore its obligation to pay.

The replacement can change interest exposure. The bond may promise fixed payments over several years. Reserves may earn an administered short-term rate that can change under the operating framework. Exchanging equal current market values therefore need not preserve future interest flows or risk. It also does not merge the treasury's legal authority with the central bank's mandate. A consolidated balance sheet answers a net-claims question. It cannot establish that either institution may perform every transaction shown in the combined accounts.

Use the table to separate transactions from responses

The worked table above is a static account of the nonbank sale. It does not simulate later lending, portfolio purchases, or inflation. Read its investor row first, then its bank row, then its central-bank row. Each asset or liability has a counterparty. The investor's deposit increase matches the commercial bank's liability increase. The commercial bank's reserve increase matches the central bank's liability increase. The bond moves between owners without a new government borrowing transaction. This reading order helps distinguish creation of a settlement claim from creation of a new loan to a household.

For guided paper exploration, suppose the investor next uses 20 of its deposit to buy an existing company bond from another customer at the same bank. Its deposit falls by 20 and its company-bond holdings rise by 20. The seller's deposit rises by 20 and its company-bond holdings fall by 20. The bank transfers the deposit between customers. Total deposits and reserves remain unchanged. The investor has altered its portfolio again, but the deposit created by the central-bank purchase now belongs partly to the company-bond seller. A single investor can reduce its money holdings without reducing the banking system's deposit total.

Change the seller of that company bond to a customer of another bank. The buyer's bank loses 20 of deposits and transfers 20 of reserves. The receiving bank gains 20 of each. Across the banks, aggregate deposits and reserves still do not change in this second transaction. Distribution changes. This is a separate paper example, not a selectable scenario in the QE table. It explains why a bank can lose some newly received reserves through payments even though the banking system cannot collectively transfer reserves to ordinary household accounts.

A bank can still make a new loan after a purchase. If it grants a separate loan of 15, it records a loan asset and deposit liability of 15. That loan requires a lending decision. Expected repayment, funding costs, capital requirements, and settlement needs remain relevant. The earlier reserve inflow is not equity and does not absorb a subsequent credit loss on the loan. If the bank later recognizes an unprovided loss of 6, its loan value and equity fall by 6. Customer deposits do not automatically fall. Loan creation, payment settlement, and loss recognition remain different entries even when they occur close together.

Portfolio responses can affect prices if investors seek assets whose available supply is limited at existing prices. A higher bond price corresponds to a lower yield for unchanged promised payments. That is a proposed transmission mechanism, not a numerical result calculated by this table. The table establishes the initial claims and payments. Estimating how strongly investors substitute between assets would require evidence about their behavior and market conditions, which these invented entries do not provide.

Distinguish a sale from maturity and fiscal spending

A central-bank sale can reverse the purchase entries under specified conditions. In an additional paper example, suppose a nonbank buys a central-bank-owned bond for 40 using its existing deposit. Its deposit falls by 40 and its bond holdings rise by 40. The commercial bank reduces its deposit liability and transfers 40 of reserves to the central bank. The central bank reduces both its bond assets and reserve liabilities by 40. This is deposit reduction through an asset purchase, not repayment of a private bank loan. No commercial-bank loan asset has changed.

If a commercial bank instead buys that bond for its own portfolio, its reserves fall by 40 and its bond assets rise by 40. Customer deposits need not change. The central bank again reduces bonds and reserve liabilities. Thus even reversal requires the counterparty distinction. A statement that central-bank securities fell by 40 is insufficient to infer that household deposits fell by 40. Other transactions during the reporting interval can also offset or amplify either balance-sheet change.

Maturity is a different event from a market sale. Consider a separate security that matures with a payment of 40, owed by the treasury to the central bank. Assume the treasury already has 40 in its central-bank account. Paying the maturing security reduces that treasury-account liability and removes the central bank's bond asset. Commercial-bank reserves need not change at this particular step. The central bank balance sheet shrinks because its liability to the treasury falls, not because a bank necessarily transfers reserves at maturity. How the treasury obtained its 40 must be traced separately.

For example, a prior tax payment could have reduced private deposits and bank reserves while increasing the treasury account. Alternatively, a prior bond issue to a nonbank could have exchanged private deposits and bank reserves for a new government bond. These financing steps have different implications for private asset holdings. If the treasury instead already held sufficient cash from an earlier period, the reserve effect need not occur in the maturity period at all. Looking only at the maturing security hides this timing distinction.

Interest also requires its own sequence. If reserves are remunerated, central-bank interest can add to a bank's income under the applicable rules. Government coupons received by the central bank and any later remittances to the treasury are separate flows. Changes in rates can alter these flows even if the purchase originally exchanged equal market values. None makes the initial principal payment an unconditional grant of bank equity. An assessment of public finances must specify which institutions are consolidated and which period's income is being measured.

To evaluate a QE claim, first identify the asset, transaction price, seller, settlement bank, and relevant public institutions. Then ask which later response the claim depends on. A claim about market yields needs a price mechanism and evidence. A claim about consumer spending needs an account of who spends the deposits and what suppliers can produce. This separates established bookkeeping from an economic hypothesis without treating either as a recommendation about whether purchases should occur.