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The figure shows 3 t-accounts. T-account (a) has the following assets: reserves = 40; bonds = 120; loans = 300. T-account (a) has the following Liabilities: deposits = 400; net worth = 60. T-account (b) has the following assets: reserves = (40 + 20 = 60); bonds = (120 – 20 = 100); loans = 300. T-account (b) has the following liabilities: deposits = 400; net worth = 60. T-account (c) has the following assets: reserves = (60 – 20 = 40); bonds = 100; loans = (300 + 20 = 320). T-account (c) has the following liabilities: deposits = 400; net worth = 60.

Where did the Federal Reserve get the $20 million that it 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 Bank can have 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.

Open market operations can also reduce the quantity of money and loans in an economy. [link] (a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market. When Happy Bank purchases $30 million in bonds, Happy Bank sends $30 million of its reserves to the central bank, but now holds an additional $30 million in bonds, as shown in [link] (b). However, Happy Bank wants to hold $40 million in reserves, as in [link] (a), so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level, as shown in [link] (c). In practical terms, a bank can easily reduce its quantity of loans. At any given time, a bank is receiving payments on loans that it made previously and also making new loans. If the bank just slows down or briefly halts making new loans, and instead adds those funds to its reserves, then its overall quantity of loans will decrease. A decrease in the quantity of loans also means fewer deposits in other banks, and other banks reducing their lending as well, as the money multiplier discussed in Money and Banking takes effect. And what about all those bonds? How do they affect the money supply? Read the following Clear It Up feature for the answer.

The figure shows 3 t-accounts. T-account (a) has the following assets: reserves = 40; bonds = 120; loans = 300. T-account (a) has the following Liabilities: deposits = 400; net worth = 60. T-account (b) has the following assets: reserves = (40 – 30 = 10); bonds = (120 + 30 = 150); loans = 300. T-account (b) has the following liabilities: deposits = 400; net worth = 60. T-account (c) has the following assets: reserves = (10 + 30 = 40); bonds = 150; loans = (300 – 30 = 270). T-account (c) has the following liabilities: deposits = 400; net worth = 60.

Does selling or buying bonds increase the money supply?

Is it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the supply of money in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.

Changing reserve requirements

A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement    , which, as we noted earlier, is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves    , they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out.

In early 2015, the Federal Reserve required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to $103.6 million, and 10% of any amount above $103.6 million. Small changes in the reserve requirements are made almost every year. For example, the $103.6 million dividing line is sometimes bumped up or down by a few million dollars. In practice, large changes in reserve requirements are rarely used to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and difficult to comply with, while loosening requirements too much would create a danger of banks being unable to meet the demand for withdrawals.

Questions & Answers

how to print
Siti Reply
what is flow variable
Siyanda Reply
a flow is a quantity that can be measured over a specific period of time
Abhishek
is economics a social science or a pure science
Hilda Reply
social science
Sammy
social science
Babarali
social Science as a Subject and Pure science as a study
Abhishek
How to compute National income by using the expenditure approach
Bridget Reply
explain the method?
Sammy
hy
Sajjad
C+I+G+(X-M) C= Consumption Expenditure I= Investment Expenditure G= Government Expenditure X-M = Net Export
Abhishek
hw r u..?
Sharat
am good
lukimia
o nice
Sajjad
please I need a guardian on this topic
Albert
What do you need? Maybe we can help
Annisa
What's going on here?
Ivan
l need some information about macroeconomic
Sharat
First tell us what you already know about macroeconomic.
Ivan
any lecturer in here?
Albert
yes !! am here !! Lecturer of Economics And Statistics
Abhishek
Macroeconomics is too vast,so please be specific your question
niguse
Briefly explain whether the discipline of economics is a social science or pure science( normative or positive)
Okafor Reply
answer.... Economics is social science
Sammy
different between absolute advantage and comparative advantage
EDSON Reply
mathematical economics
masele Reply
show some questions under this topic
hassan
why met worth is added with libilitys in the balance sheet
bijoy Reply
what are the implications of inflation targeting?
Alinaitwe Reply
maximize profit
Murry
What happens to the goods and money market if the government cuts public spending?
Harman Reply
then the government will be punished by the public
soul
GDP, INFLATION, UNEMPLOYMENT & PRODUCTIVITY and then write a paragraph on the behavior of each variable after analyzing them graphically.
AWY
what is international trade
Stella Reply
International trade is the exchange of capital, goods, and services across international borders.
Bilal
international trade is the exchange of goods and services across boundaries
Zamu
international trade is the exchange of goods and services of country and abroad
Uwase
international is the process of exchanges of value interm of goods and services along national frontier
Murry
Trade*
Murry
Increase knowdge and skill. it save time and cost. Increase high Efficiency of production .
betta Reply
List kinds of Elastcity of Demand
betta
Is a faster rate of economic growth always a good thing as compared to a slower rate? And why?
LIMPHO Reply
what is unemployment
Doctor Reply
it is a situation during which workers remain jobless.
Zeeshan
is situation where people are willing to work but job are no available
Uwase
what is inflation
Sheila Reply
Inflation is a major concern to global economists, and it affects people from all walks of life. It refers to the measure or rate by which the cost of goods and services rises and purchasing power declines. As prices increase, monetary value decreases—prompting consumers to spend less on goods and s
King
inflation is the persistence rise in price level
Zamu
Inflation is the situation during which too much money is required to purchase too few goods.
Zeeshan
inflation is continuous increase in general price level
Uwase
it is the process where too much money pursuing fewer goods
Murry

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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