How Does Buying Government Securities Affect The Money Supply

Learning Outcomes

• Explicate and demonstrate how the key banking company executes monetary policy through open marketplace operations

Open up Market place Operations

The most commonly used tool of monetary policy in the U.Southward. is open market operations. Open marketplace operations take place when the central bank sells or buys U.S. Treasury securities in club to influence the quantity of bank reserves and the level of interest rates. When the Fed conducts open market operations, it targets the federal funds rate, since that interest charge per unit reflects credit weather in fiscal markets very well.

Decisions regarding open market place operations are made by the Federal Open Marketplace Committee (FOMC). The FOMC is made up of the seven members of the Federal Reserve'due south Lath of Governors, plus 5 voting members who are fatigued, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent voting member of the FOMC and the other four spots are filled on a rotating, almanac footing from the other xi Federal Reserve districts. The FOMC typically meets every six weeks, only it tin encounter more frequently if necessary. The FOMC tries to act by consensus; withal, the chairman of the Federal Reserve has traditionally played a very powerful office in defining and shaping that consensus. For the Federal Reserve, and for near central banks, open marketplace operations take, over the last few decades, been the most commonly used tool of monetary policy.

In the module on Money & Cyberbanking, we introduced the loan expansion procedure past which commercial banks lend out excess reserves. The loans are in the form of new checking account balances, which become part of the money supply. We used the money multiplier defined as i/Required Reserve Ratio to develop a formula for determining how much the money supply increases through the loan expansion procedure. When the Federal Reserve conducts open up market operations to increase the money supply by purchasing Treasury bonds, since the Fed pays with money coming from outside the cyberbanking system, the money supply increases more than if someone deposited cash (which was already counted as function of the M1 coin supply).

To understand how open marketplace operations bear on the money supply, consider the balance sheet of Happy Banking company, displayed in Figure ane. Figure ane(a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 meg in liabilities in the grade of deposits, with a net worth of $60 one thousand thousand. When the central depository financial institution purchases $twenty million in bonds from Happy Bank, the bond holdings of Happy Bank fall past $20 one thousand thousand and the depository financial institution's reserves rise by $20 million, as shown in Figure 1(b). However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves that it started with in Effigy 1(a), then the banking company decides to loan out the extra $xx 1000000 in reserves and its loans rise past $20 million, as shown in Figure 1(c). The open market operation by the central depository financial institution causes Happy Banking company to make loans instead of holding its assets in the form of government bonds, which expands the money supply. As the new loans are deposited in banks throughout the economy, these banks will, in plow, loan out some of the deposits they receive, triggering the money multiplier and increasing the supply of coin.

Figure 1. Residuum Sheets for Happy Bank. Effigy 1(a) shows that Happy Bank starts with $460 million in avails. In (b), the Federal Reserve purchases $twenty million in bonds from Happy Bank, which lowers Happy Bank'south bonds holdings, but increases their bank reserves by $20 million. In (c), Happy Banking company decides to loan out that $20 million, thereby increasing their loans.

Try It

Where did the Federal Reserve get the $20 million that information technology used to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Banking company can take that money credited to its bank account at the Federal Reserve. In truth, the Federal Reserve created the money to purchase the bonds out of thin air—or with a few clicks on some computer keys.

Using the Coin multiplier Formula

How much did the Fed's $20 million open market purchase of bonds increase the money supply? We can use the following formula to find out, recalling that since the reserve requirement is ten%, the money multiplier is ten:

[latex]\displaystyle\text{Change in the Money Supply}={\text{Coin Multiplier}}\times\text{Corporeality of Fed'southward Bond Purchase}[/latex]

Or in other words,

[latex]\displaystyle\text{Change in the Money Supply}={\text{Coin Multiplier}}\times\text{Change in Banking concern Reserves}[/latex]

then,

[latex]\displaystyle\text{Change in the Money Supply}=ten\times{twenty}\text{ million}=200\text{ million}[/latex]

One final note: In the example above, the Fed purchased bonds from Happy Bank, simply that is not necessary for monetary policy to play out. The Fed purchases bonds from whoever owns them. Information technology could exist a banking company, or a corporation or a person. As long equally the bond seller deposits the Fed's payment in a depository financial institution, the process plays out every bit described.

Open market operations tin as well reduce the quantity of coin and loans in an economy. Figure 2(a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open marketplace. When Happy Bank purchases $thirty million in bonds, Happy Bank sends $30 million of its reserves to the central bank, only now holds an additional $thirty million in bonds, as shown in Figure 2(b). However, Happy Bank wants to hold $40 meg in reserves, every bit in Figure 2(a), then it will arrange down the quantity of its loans by $30 1000000, to bring its reserves back to the desired level, as shown in Figure 2(c). In practical terms, a depository financial institution can easily reduce its quantity of loans. At any given time, a banking company is receiving payments on loans that it made previously and also making new loans. If the bank simply slows downwards or briefly halts making new loans, and instead adds those funds to its reserves, and then its overall quantity of loans will decrease. A decrease in the quantity of loans likewise ways fewer deposits in other banks, and other banks reducing their lending also, as the money multiplier takes effect. And what well-nigh all those bonds? How do they bear upon the money supply? Read on to find out.

Effigy 2. Residue Sheets for Happy Bank. When Happy Depository financial institution purchases $xxx million in bonds, Happy Bank sends $30 meg of its reserves to the central banking company, just now holds an boosted $30 1000000 in bonds, equally shown in (b). For Happy Bank to maintain its level of reserves at $40 million, information technology needs to reduce its quantity of loans, as shown in (c).

Endeavor It

DOES SELLING OR BUYING BONDS INCREASE THE Coin SUPPLY?

Is information technology a sale of bonds by the fundamental bank which increases bank reserves and lowers interest rates or is information technology a purchase of bonds by the key bank? The easy fashion to keep track of this is to treat the central bank as beingness exterior the banking system. When a cardinal depository financial institution buys bonds, money is flowing from the key bank to individual banks in the economy, increasing the supply of money in circulation. When a key bank sells bonds, then money from private banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.

Watch it

Watch this video to review how the FED uses open market operations to influence involvement rates.

You can view the transcript for "Segment 406: Open up Market Operations" here (opens in new window).

Glossary

open market operations:

the central bank selling or buying Treasury securities to influence the quantity of coin and the level of involvement rates

open market purchase:

the key bank buys Treasure securities to increase bank reserves and lower interest rates

open up market sale:

the central bank sells Treasure securities to decrease banking company reserves and raise involvement rates

Did you have an idea for improving this content? We'd love your input.

Source: https://courses.lumenlearning.com/wm-macroeconomics/chapter/monetary-policy-and-open-market-operations/

Posted by: charonpree1959.blogspot.com

Share this post