Central Bank purchases of private assets: An evaluation

We develop a model of asset exchange and monetary policy, augmented to incorporate a housing market and a frictional financial market. Homeowners take out mortgages with banks using their residential properties as collateral to finance consumption. Banks use mortgages and government liabilities as collateral to secure deposit contracts, but they have an incentive to falsify the quality of mortgages at a cost. Quantitative easing in the form of central bank purchases of mortgages from private banks has an effect on the composition of assets in the economy and on the incentive structure of the private sector. When the incentive problem is severe, private banks hold capital with mortgage retention to mitigate the incentive problem, and the central bank can unambiguously improve welfare by purchasing mortgages. However, when this problem is not severe, the central bank's mortgage purchases cause a housing construction boom and can sometimes decrease an exchange in the economy, thereby reducing welfare.