Central Bank Transactions

Transactions by the central bank can have a significant effect on the economy. These transactions always change the central bank's balance sheet and will often change the supply of money. In the previous article, we examined the relationship between supply money and the central bank's balance sheet, as exemplified by the Federal Reserve (Fed). Now we will look at the type of transactions that the Federal Reserve and most other central banks engage in to effect monetary policy.

There are 3 fundamental types of transactions that change the supply of money:

1. open-market operations, where the central bank buys or sells securities, usually government bonds;
2. foreign exchange interventions, where a central bank exchanges domestic currency for foreign currency; and
3. discount loans to commercial banks.

Open-Market Operations: Regulating the Money Supply

When the Fed buys or sells securities, which are almost always Treasuries, it buys or sells to one or more of its 18 primary dealers as an open market operation. Because most of these dealers and financial markets are in New York City, the New York Federal Reserve does the actual buying or selling. These dealers are selected because of their size, reputation, and because of their willingness to buy or sell securities when the Fed wants to sell or buy.

For instance, to stimulate the economy and decrease unemployment, the Fed decided in late 2010 to increase the money supply by purchasing $600 billion worth of Treasuries. Over time, the Fed will purchase the securities from its primary dealers, and increment their reserve accounts at the Fed by $600 billion. This transaction expands the Fed's balance sheet because it increases its liabilities by $600 billion and its assets by the same amount.

The dealers' reserves held at the Fed are a liability to the Fed but an asset to the dealers. Because dealers are no longer holding the Treasuries which were generating interest, they will seek to invest it elsewhere, creating demand for other products and services. Because the Fed purchased the Treasuries, it increased demand for the Treasuries, thereby increasing their price, which is inversely related to their interest rate. Hence, the lower interest rate will make money more readily available to the economy and hopefully stimulate it, which, of course, was the Fed's intention. The money supply is increased because non-spendable Treasuries were exchanged for reserve balances, which is money.

After lowering the short-term interest rates to near 0, the economy still did not grow significantly faster, so the Fed resorted to quantitative easing: buying longer-term Treasuries and mortgage-backed securities to reduce the long-term interest rate. Only after 3 rounds of quantitative easing did the economy grow faster, reaching its potential output by 2018.

If the Fed had decided to sell Treasuries, then the changes in the balance sheets of both the primary dealers and the Fed would be reversed.

Foreign Exchange Transactions

Sometimes central banks engage in foreign exchange transactions, usually to maintain liquidity in foreign currencies or to affect the currency exchange rate. A foreign-exchange market intervention is foreign exchange transactions by the central bank for the purpose of influencing exchange rates.

However, since 1990, few central banks have attempted to intervene in the foreign exchange markets, because such interventions have had, at best, a temporary effect, as one study of the massive Japanese interventions from 1991 to 2004 has shown. The foreign-exchange market is simply too big even for a central bank to manipulate it. Central banks generally hold foreign reserves to provide liquidity to service the needs of its domestic economy, and usually only those currencies with a higher value than the domestic currency, since cheaper currencies can simply be bought on the open market. Furthermore, the bonds of the foreign government are held rather than the currency itself, all the currency must be bought 1st to buy the bonds.

For instance, when the Federal Reserve wants to buy euros, it will buy euros with dollars, then purchase the bonds. Thus, if the Fed buys $1 million worth of bonds denominated in euros from a German bank with an account at the Fed, it simply increases the bank's reserves in its account at the Fed by $1 million worth of euros in exchange for the bonds, which are also transmitted electronically as a book entry value.

Discount Loans

A discount loan is a loan made by the Fed to a commercial bank. Commercial banks borrow from the Fed usually to cover shortfalls in their own reserves. However, to borrow the money, the commercial bank must supply the Fed with collateral, usually in the form of Treasuries. This increases the money supply because reserves are spendable whereas Treasuries are not. As with security purchases, the Fed simply increases the borrower's reserve account, thus, creating money. When the borrowing bank pays back the Fed, it will receive its collateral, while its own reserves will be lessened by the amount of the loan repayment, thus, decreasing the money supply. Usually, discount loans are overnight, in which case, they don't affect the money supply, but sometimes, such as during the Great Recession, the Fed extended the terms of its loans for longer periods.

Discount lending is not a main tool of the Fed but of one of last resort for the borrowers. Most commercial banks borrow from one another in the interbank market. These loans are generally provided without collateral, although at a higher interest rate; hence, only creditworthy banks could obtain these loans. Only when a bank could not get a loan from the interbank market would it turn to the Fed. In spite of the lower interest rate, banks hesitate to borrow from the Fed because it indicated that they were not creditworthy to borrow from other banks, thus inviting increased scrutiny from the Fed. Nonetheless, discount lending exploded in the Great Recession because banks could not know which ones were creditworthy and were, thus, hesitant to lend, limiting the availability of credit to the economy. Hence, the balance sheet changes after a $1 million discount loan would be:

Cash Withdrawal

The withdrawal of cash by the public changes the balance sheet of the central bank and of the bank where the money was actually withdrawn, but it does not change the supply of money. The central bank controls the composition of its assets, because it can convert one asset into another if it wishes. But because it stands ready to exchange banking reserves for currency — both liabilities of the central bank — the public, in its demand for currency, determines the composition of the central banks liabilities. Because vault cash is part of the bank's reserves, which is a Fed liability, any withdrawals by the public decreases the amount of reserves. So if you withdraw $100 from your checking account as cash, then the Fed's bank reserve liability decreases by $100, but its currency liability increases by the same amount, since currency is a liability of the Federal Reserve, as evidenced by the phrase Federal Reserve Note at the top of all U.S. currency. The balance sheets would look like this after the $100 cash withdrawal: