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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

Which of the following are assets of the Federal Reserve? a. Treasury bills held by the Federal Reserve b. cash in circulation c. Loans made by commercial banks d. the reserves of commercial banks at the Federal Reserve
Julya Reply
D
Neeha
a
Sushovan
d
Roger
what are the four functions served by money
Michele Reply
It serves as a medium of exchange
Zaharaddeen
It serves as a store of value
Zaharaddeen
It serves as a unit of account
Umar
It also serves as a standard for Differed Payment.
Umar
Acts as a measure of value.
Humphrey
acceptability
GGPS
hi
Shaxboz
hello
Md
welcome
Shaxboz
Hey, I am a new member.
Abdul
Store of value
Bokwe
can anyone tell me that why in the income and consumption curve the income is on x axis?
bechar Reply
why inflation in double digit is not good for economy
Obaid Reply
what is mean by zero inflation
Obaid
some time it is good but some time it is not...
bechar
the condition of that economy tell you. is it good are bad?
bechar
the definition of the law of demand
Aley Reply
law of damand states all else remains constant or what we can say is ceteris peribus,quantity demanded for a commodity extends with fall in price and vice versa. law of demand explains inverse relationship between price and qua ntity demanded
Gaurav
What is demand and supply
Antwi Reply
what is gdp per capital and why it is used for?
Era Reply
gross domestic product
prince
gdp per capita is the gross domestic product per person (GDP/population) and is a better indicator of economic health and living standards than GDP alone.
Gina
thank you so much 😘
Era
please explain shift in production possibility curve
Kobby
advances in technology can cause a shift in the ppf because output can increase with use of the same amount of resources (laborers can produce more efficiently, and suppliers are willing to sell more)
Gina
but equally natural shocks ie earthquakes or war can move the ppf inward so reducing production capicity
jax
what is crowding out effect?
Sera Reply
What is SAT AND GPA
prince
What to read the introduction
prince Reply
Keynesian theory of employment
sainlangki Reply
it's about use of Fiscal policy.
yvonne
yar what actually means of APc. averge means?. can someone give a best example plz
Asrar Reply
APC is average propensity to consume n this refers to ratio of consumption expenditure to corresponding level of income
Vishakha
then it means both MPC and ApC are same ?
Asrar
No..... APC is average propensity to consume whereas MPC is marginal propensity to consume
Vishakha
APC=C/I , MPC=∆C/∆I
Vishakha
which model predicted a global collapse in the world's social and economic system before the year 2010
Francis Reply
trade deficit
Amadou
is trade deficit the correct answer?
Abinash
yes
Amadou
what is the formula of mixed income ?
Sanjum Reply
NDPfc = COE + OS +MI MI=NDPfc- COE- OS
Vishakha
labor force in.Nigeria is seen as .......?
Aisha Reply
Is demand the same as being in need of a product?
Aphiwe Reply
yeah
Demand is defer from only need of products
Zubairu
need is the primary and main root of demand. but demand is the result of combination of need; income capacity and desire to expend of money for that product.
Ramu
products or services
jax

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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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