14.2 Open Market Operations

We are now ready to understand how the central bank influences the money supply (MS) with the aid of the T-accounts we first encountered in Chapter 9 "Bank Management". Central banks like the Fed influence the MS via the MB. They control their monetary liabilities, MB, by buying and selling securities, a process called open market operations. If a central bank wants to increase the MB, it need only buy a security. (Any asset will do, but securities, especially government bonds, are generally best because there is little default risk, liquidity is high, and they pay interest.) If a central bank bought a $10,000 bond from a bank, the following would occur:

The banking system would lose $10,000 worth of securities but gain $10,000 of reserves (probably a credit in its account with the central bank but, as noted above, FRN or other forms of cash also count as reserves).

The central bank would gain $10,000 of securities essentially by creating $10,000 of reserves. Notice that the item transferred, securities, has opposite signs, negative for the banking system and positive for the central bank. That makes good sense if you think about it because one party is selling (giving up) and the other is buying (receiving). Note also that the central bank’s liability has the same sign as the banking system’s asset. That too makes sense because, as noted above, the central bank’s liabilities are everyone else’s assets. So if the central bank’s liabilities increase or decrease, everyone else’s assets should do likewise.

If the central bank happens to buy a bond from the public (any nonbank), and that entity deposits the proceeds in its bank, precisely the same outcome would occur, though via a slightly more circuitous route:

If the nonbank seller of the security keeps the proceeds as cash (FRN), however, the outcome is slightly different:

Note that in either case, however, the MB increases by the amount of the purchase because either C or R increases by the amount of the purchase. Keep in mind that currency in circulation means cash (like FRN) no longer in the central bank. An IOU in the hands of its maker is no liability; cash in the hands of its issuer is not a liability. So although the money existed physically before Some Dude sold his bond, it did not exist economically as money until it left its papa (mama?), the central bank. If the transaction were reversed and Some Dude bought a bond from the central bank with currency, the notes he paid would cease to be money, and currency in circulation would decrease by $10,000.

In fact, whenever the central bank sells an asset, the exact opposite of the above T-accounts occurs: the MB shrinks because C (and/or R) decreases along with the central bank’s securities holdings, and banks or the nonbank public own more securities but less C or R.

The nonbank public can influence the relative share of C and R but not the MB. Say that you had $55.50 in your bank account but wanted $30 in cash to take your significant other to the carnival. Your T-account would look like the following because you turned $30 of deposits into $30 of FRN:

Your bank’s T-account would look like the following because it lost $30 of deposits and $30 of reserves, the $30 you walked off with:

The central bank’s T-account would look like the following because the nonbank public (you!) would hold $30 and your bank’s reserves would decrease accordingly (as noted above):

The central bank can also control the monetary base by making loans to banks and receiving their loan repayments. A loan increases the MB and a repayment decreases it. A $1 million loan and repayment a week later looks like this:

Take time now to practice deciphering the effects of open market operations and central bank loans and repayments via T-accounts in Exercise 1. You’ll be glad you did.