The process of quantitative easing directly leads to an expansion of commercial bank reserves on the central bank's balance sheet. When the central bank purchases bonds, it pays for them by creating new base money. The sellers of these bonds, typically financial institutions, deposit this new money into their commercial bank accounts. The commercial banks, in turn, deposit these funds, often referred to as 'excess reserves', in their own accounts at the central bank. This chain of transactions is the mechanism behind the significant rise in central bank liabilities observed during periods of QE.

How Quantitative Easing Increases Central Bank Reserves

Prior to the era of quantitative easing (QE), central banks conducted monetary policy by maintaining a banking system with minimal excess reserves. By keeping the level of excess reserves close to zero, the creation of bank deposits through central bank asset purchases was not a significant monetary mechanism.

Pre-QE Monetary Policy and Reserve Management

The observation that commercial bank reserves were a relatively minor liability for central banks like the Bank of England before the 2007-2009 financial crisis, but expanded dramatically afterward, raises a key question: Why did this significant growth in reserves occur in the UK and many other nations in recent years?

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Figure 6.11 illustrates the historical evolution of the Bank of England's liabilities, normalized as a percentage of the UK's nominal GDP, from 1946 to 2023. The chart highlights two key trends. First, it shows a long-term downward trend in the value of banknotes in circulation relative to GDP, which reflects a societal shift towards alternative payment methods. Second, it reveals that commercial bank reserves were a minor component of central bank liabilities before the 2007–2009 financial crisis but expanded significantly afterward, a trend associated with quantitative easing (QE).

Figure 6.11: Bank of England Liabilities as a Percentage of GDP (1946–2023)

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Macroeconomics

Historically, the total value of banknotes in circulation has shown a long-term downward trend when measured as a percentage of Gross Domestic Product (GDP). This decline is attributed to a widespread and progressive shift towards using alternative methods of payment instead of physical cash.

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