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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.

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