Question about open market operations

Economics Economics Questions
1

My question is about the actual operations of a central bank. As I understand it, the way central banking is alleged to work is that banks will deposit their reserves with the central bank, and these pooled reserves will be used to bail out banks that experience a panic.

For example if a banks collectively have $1M worth of demand deposits and $100k of cash reserves, these reserves will be deposited with the central bank and used to issue emergency loans.

When the central banks wants to lower the interest rate it goes into the open market and purpases assests and through the miricle of fractional reserve banking the money supply expands. My questions what money does the central bank use to purchase these assets. Money from the pool of reserves on accout with the cetnral bank, or does it leave the reserves untouched and litterally writes checks out of thin air?

2

To answer your question, let’s look at the Federal Reserve Balance Sheet. Here is a very simplified example:

Note: Numbers in millions of dollars

Assets Liabilities
Gold 9,000 Federal Reserve Notes 1,000,000
Treasury Securities 2,000,000 Member Bank Reserve Deposits 1,000,000
Bank Premises 1,000
Other Assets 40,000
Capital Accounts
Capital Paid In 25,000
Surplus 20,000
Other Capital Accounts 5,000
Total 2,050,000 Total 2,050,000

Member banks are required to deposit with the Fed a minimum amount of their reserves. For the above example, the total of these reserves are labeled “Member Bank Reserve Deposits” at $1,000,000 million (highlighted in yellow).

Let’s say the Fed decides to increase the money supply by $2,000,000 million over a period of time, then through Open Market Operations, it would purchase $2,000,000 million of treasury securities on the private market.

This is reflected on the balance sheet is as follows:

Assets Liabilities
Gold 9,000 Federal Reserve Notes 1,000,000
Treasury Securities 4,000,000 Member Bank Reserve Deposits 1,000,000
Bank Premises 1,000
Other Assets 40,000
Capital Accounts
Capital Paid In 25,000
Surplus 20,000
Other Capital Accounts 5,000
Total 4,050,000 Total 2,050,000

For the above example, the amount labeled “Treasury Securities” (highlighted in yellow) increases from $2,000,000 million to $4,000,000 million, an increase of $2,000,000 million. This be be done by purchasing treasury securities from private security dealers, who in return receives checks from the Fed.

Notice the total amounts for the assets and liabilities plus capital accounts (both highlighted in green) are not equal. Per accounting rules, both total amounts must be in balance, i.e. equal to each other.

The private security dealers take the Fed issued checks, and deposit them into their respective member banks.

The Fed, upon check settlement, credits the respective member bank’s reserve deposit at the Fed, as follows:

Assets Liabilities
Gold 9,000 Federal Reserve Notes 1,000,000
Treasury Securities 4,000,000 Member Bank Reserve Deposits 3,000,000
Bank Premises 1,000
Other Assets 40,000
Capital Accounts
Capital Paid In 25,000
Surplus 20,000
Other Capital Accounts 5,000
Total 4,050,000 Total 4,050,000

For the above example, the amount labeled “Member Bank Reserve Deposits” has increased from $1,000,000 million to $3,000,000 million, an increase of $2,000,000 million.

Notice the total for both the assets and liabilities plus capital accounts (highlighted in green) are now equal to each other.

To answer your question, the Fed writes a check against nothing, payable to a security dealer, who then deposits the check at a member bank. Then once the check settles, the Fed credits the amount to the member bank’s reserve account at the Fed.

But of course, this is all done electronically, so in reality, no paper check is actually issued. The Fed directly credits the account, electronically.

To be candid, this is how it’s done in theory. I am not completely sure what the actual steps are, but this should provide a general idea.

3

Thank you for your answer. The bigger question is why do people view this as legitimate? I could see if you are a believe in fractional reserve banking and believe that a pool of reserves is necessary to bail out banks during a panic, but how does anyone justify the central banking writing checks against nothing, as opposed to writing checks on the pool of bank reserves?

4

Earlier I mentioned “the Fed writes a check against nothing”, which I realized is not entirely correct. The Fed writes a check against the Federal Reserve Notes, which are the printed banknotes you currently carry around in your wallet.

These Federal Reserve Notes are liabilities against the assets held by the Fed.

In principal, you should be able to take a $100.00 bill to any Federal Reserve Bank, and demand payment in some Fed assets (for example, redeem your note for gold or silver). In practice, that is not allowed anymore by law.

Basically, the Federal Reserve Notes are nonredeemable, backed by the “full faith and credit of the U.S. government”, unless the Fed agrees to exchange your note for an asset.

For example, the Fed sells treasury securities (or possibly gold) on the open market, which is the equivalent of the Fed redeeming the Federal Reserve Notes.

Think about this in another way, a private securities dealer “deposits” treasury bills with the Fed, which the Fed in return issues to him Federal Reserve Notes as a demand claim against those assets.

Later on, the dealer can return and “redeem” those same notes with the Fed in exchange for some assets.

In theory, the Fed cannot increase the number of Federal Reserve Notes, unless those notes are backed by an equivalent asset.

In a previous era, those assets would be gold. Every time a member bank deposits gold with the Fed, the Fed can issue more gold backed demand notes to the bank.

But since the Federal Reserve Notes are not backed by gold anymore, any increase to the Federal Reserve Notes must be backed up by some asset, usually U.S. treasury securities, or later on a portfolio of risky assets from a failed financial institution.

To rephrase my previous answer: the Fed writes a check against the Federal Reserve Notes to be issued, which are demand claims against the Federal Reserve assets, payable to a security dealer. who then deposits the check at a member bank.

Then once the check settles, the Fed credits the member bank with an equivalent of recently issued Federal Reserve Notes, that came into existence because of an increase in Fed assets. This increase came from the purchase of the treasury securities from the securities dealer.

Having deposited the check, the security dealer can later on withdraw the Federal Reserve Notes and attempt to redeem those notes and demand payment in assets from the Fed.

The Fed will not do it, unless the Fed agrees to exchange some of those assets for those notes.

If the Fed does agree to exchange the notes for some assets, then in essence, that would be a reverse transaction through Open Market Operations, which the Fed simply sells the treasury security for cash to the securities dealer.

That all said, the real question should be this: why would the public accept nonredeemable banknotes?