Undertaken at the Fed’s own initiative, open market operations are the mainstay of Federal Reserve policy.
About $4,000 billion worth of marketable government securities are outstanding. They are held as investments by the public-by individuals, corporations, financial institutions, and so on. Over $300 billion are held by the Federal Reserve system. These government securities came into being when the U.S. Treasury had to borrow to finance budget deficits. This pool of widely held marketable securities, with many potential buyers and sellers, offers an ideal vehicle through which the Federal Reserve can affect bank reserves. Federal Reserve purchases of government securities increase bank reserves, and Federal Reserve sales decrease them.
When the Federal Reserve buys $1,000 of government securities, much as you might buy a stock or a bond on one of the stock exchanges, it pays with a check drawn on itself. If the Fed buys the securities directly from a commercial bank-say, from a bank in Succasunna, New Jersey-the Succasunna bank sends the Fed’s check to its regional Federal Reserve bank (the Federal Reserve Bank of Philadelphia) and has its deposit at the Fed-its reserves-increased by $1,000. The Succasunna bank’s excess reserves rise by the full amount of the transaction, and with more excess reserves it can make more loans and increase its demand deposits.
But what the central bank giveth, the central bank can taketh away. When the Federal Reserve sells government securities out of its portfolio, it gets paid for them, and everything is reversed. Say the Fed sells $1,000 of government securities directly to our friendly Succasunna bank; the Succasunna bank now has gained $1,000 worth of securities, which is good, but it has to pay for them, which is bad. The Fed takes payment by deducting that sum from the Succasunna bank’s deposit at the Federal Reserve, thus diminishing its reserves. If you were to draw up the T-accounts for the transaction, everything would be exactly the same as the T-accounts above, except that every plus sign would become a minus and every minus sign a plus. The Succasunna bank’s excess reserves fall by the full amount of the transaction; if it had no excess reserves, now it has a $1,000 reserve deficiency.
Note that the Federal Reserve could achieve the same ends-that is, change bank reserves-by buying or selling any asset, such as any type of bond or stock, or even CD recordings. The reason for limiting its open market operations to the purchase and sale of government securities is quite obvious: Who would determine whether the Federal Reserve should buy Michael Jackson or Bruce Springsteen albums? General Motors stock or IBM? The Federal Reserve is smart enough, at least in this respect, not to get involved in the really important decisions.
Of course, when the Federal Reserve buys (or sells) government securities, it has no assurance that a bank will be the other party to the transaction. But it doesn’t matter whether the securities the Fed buys are being sold by a bank or by someone else, nor is it important whether the securities the Fed sells are ultimately bought by a bank or by someone else. In either case, when the Fed buys, bank reserves go up, and when the Fed sells, bank reserves go down.
For example, suppose that when the Fed bought $1,000 of government securities, the seller of the securities wasn’t the Succasunna bank but an insurance company in Mishawaka, Indiana. It wouldn’t matter if the insurance company were in Cut Off, Louisiana; Zap, North Dakota; Searchlight, Nevada; or even Eureka, California. However, this insurance company happens to be in Mishawaka, Indiana.
In any case, when the Fed buys, it still pays for the securities with a check drawn on itself. When the insurance company deposits the check in its local commercial bank, the Mishawaka bank now has the Federal Reserve’s check (an asset), and it gives the insurance company a demand deposit. In turn, the Mishawaka bank sends the check to its regional Federal Reserve bank (the Federal Reserve Bank of Chicago) and receives in exchange a $1,000 addition to its reserves.
The T-account for the insurance company shows that it now has $1,000 less in government securities and $1,000 more in its demand deposit account at its local commercial bank. For the Federal Reserve and the Mishawaka bank, the T-accounts for such a Federal Reserve purchase.
Notice that in this case the commercial bank’s excess reserves go up, but not by the full amount of the transaction. The bank has $1,000 more of reserves, but it needs $100 more (assuming a 10 percent reserve requirement), because its deposits have gone up by $1,000; thus its excess reserves have risen by $900. However, the money supply has already risen by $1,000, so the ultimate potential effect on the money supply is the same regardless of where the Fed buys its securities. To summarize:
- If the Fed buys $ 1,000 of government securities directly from commercial banks, bank excess reserves rise by the full $1,000 and the banking system can then create $10,000 of new money (assuming a 10 percent reserve requirement).
- If the Fed buys from nonbanks, bank excess reserves rise by only $900 and the banking system can create $9,000 of new money. But the money supply has already gone up by $1,000, and $9,000 + $1,000 also equal $10,000. So, in the end, the ultimate effect on the money supply of either type of open market purchase turns out to be the same.
Commercial banks are unable to do anything to offset these measures. If the Fed wants to reduce bank reserves by open market sales, there is nothing the banks can do about it. By lowering its selling price, the Fed can always unearth a buyer. Since it is not in business to make a profit, the Fed is free to alter its selling price as it wishes. And while any single commercial bank can replenish its own reserves by selling securities to other banks-or to individuals who keep their accounts in other banks-the reserves of the other banks will then decline. Reserves replenished by one bank are lost by others.
Total bank reserves must fall by the value of the securities sold by the Federal Reserve.
It should now be clear why a contraction or expansion in the money supply via pure monetary policy does not change the total size of the public’s portfolio (its wealth) directly. The public gives up an asset, or incurs a liability, as part of the very process through which currency or demand deposits rise; the reverse occurs when demand deposits decline. For example, if the money supply is increased by the Federal Reserve’s open market purchases of securities, the increased demand deposit acquired by the public is offset by the reduction in its holdings of government securities (they were purchased by the Federal Reserve). In any subsequent expansion of demand deposits by bank lending or security purchases, the public acquires an asset (demand deposits) but either creates a liability against itself in the form of a bank loan or sells to the bank an asset of equal value, such as a government bond.