Skip to main content

Suppose the Reserve Bank sells $50 million of government securities to Bank A. Explain and show the effect of this action on the balance sheets of...

In what is called open market operations, the Federal Reserve can effectively create or destroy money by buying or selling bonds to banks. If they create money, this is called expansionary monetary policy; if they destroy money, this is called contractionary.

If they sell bonds to a bank, they are effectively removing that bank's money from the system. The bank is willing to do this because they get an asset---the Treasury bonds---that is worth as much to them as the money they lose. Eventually that bond will mature and pay out to the bank, but until then that money is not in the system.

Using this example, if the Fed sells $50 million in Treasury bonds to Bank A, the bank's balance sheet will show the loss of one asset---the cash reserves of $50 million---and the gain of another asset of equal market value---the Treasury bonds. Since the banks now have less reserves than they wanted, they will have less money to lend, and will raise interest rates. Based on the reserve requirement, they may be forced to cut back their lending, simply to ensure that they have enough reserves to meet the requirement.

The Fed's balance sheet will show the loss of the Treasury bonds asset---but it will record the cash quite differently. Instead of showing a gain of an asset, the Fed's balance sheet will show the loss of a liability---all monetary base in circulation is recorded as a liability to the Federal Reserve.

Thus, while the total balance of the Federal Reserve is constant (zero), the actual amount of assets and liabilities can vary by literally trillions of dollars, as the Fed has the unique power to create and destroy monetary assets and liabilities at will. Put another way, A - L = 0 always, but A + L can be whatever the Fed wants it to be (and is essentially a measure of our monetary base).

The lower the reserve requirement, the larger the decrease in money supply from selling Treasury bonds will be. This is because the reserve requirement creates a multiplier effect---the money multiplier---inverse to the reserve requirement. So for example, a 5% reserve requirement is a multiplier of 1/0.05 = 20, while a 10% reserve requirement is a multiplier of 1/0.10 = 10. The Fed also modifies the reserve requirements sometimes to reach a target level of money supply and interest rates.

Popular posts from this blog

In chapter one of The Great Gatsby, what advice does Nick's father give him? How does this make him a good person to tell this story?

Nick says that his father advised him that, before "criticizing anyone," he "remember that all the people in this world haven't had the same advantages" as Nick.  As a result, Nick claims that he is "inclined to reserve all judgments," presenting himself to the reader as a fair and dispassionate arbiter of character, and thus, a reliable narrator.   The problem is that Nick immediately reveals himself as anything but reliable, as he then launches... Nick says that his father advised him that, before "criticizing anyone," he "remember that all the people in this world haven't had the same advantages" as Nick.  As a result, Nick claims that he is "inclined to reserve all judgments," presenting himself to the reader as a fair and dispassionate arbiter of character, and thus, a reliable narrator.   The problem is that Nick immediately reveals himself as anything but reliable, as he then launches into a discussion of how pe...
Post a Comment
Read more

How did the United States become an imperial power?

"Imperial power" is a bit of a vague label. It tends to mean several things at once, so let's unpack it. In the sense of "this country was built on conquest by force," the "imperial power" part of America actually predates the United States proper. The territories that would become the United States were imperial colonies, established by the great European empires of the 17th and 18th centuries. Much of the US Constitution and American governance generally goes back to England, history's largest and most successful imperial power, but vital aspects of American culture come from other imperial powers, such as France and Spain. Much of American culture comes from sources other than the old empires, but they were key influences on what the United States became. In the sense of "this country treats conquest by force as a fundamental component of its culture, economy and politics," the United States has always been an imperial power. Even earl...
Post a Comment
Read more

How and why does James Gatz become Jay Gatsby? Describe the young Gatsby/Gatz.

James Gatz, a poor Midwestern boy of probable Jewish lineage, becomes Jay Gatsby, a presumed WASP and wealthy socialite, when he moves to New York City and acquires his fortune. It is wealth that has allowed Gatz to transform himself into Gatsby. However, those who know his background (e.g., Daisy and Tom Buchanan) never allow him to forget that he is nouveau riche -- that is, an upstart who has just recently made his fortune,... James Gatz, a poor Midwestern boy of probable Jewish lineage, becomes Jay Gatsby, a presumed WASP and wealthy socialite, when he moves to New York City and acquires his fortune. It is wealth that has allowed Gatz to transform himself into Gatsby. However, those who know his background (e.g., Daisy and Tom Buchanan) never allow him to forget that he is nouveau riche -- that is, an upstart who has just recently made his fortune, whereas they arose from well-to-do families. Gatz became Gatsby through determination and discipline. At the end of the novel, the narr...
Post a Comment
Read more