What happens when a central bank buys government bonds?

Economics Economics Questions
1

When a central bank buys some government bonds, do the bonds just get thrown away as if they had never existed? Or are they somehow still active - i.e. is the government still obliged to pay the coupon and eventually the principal on them?

So for example I can see one of two scenarios being true:

Scenario A:
The government create 10billion of bonds and sells them to
the private sector.
The government debt is now 10 billion.
Then the fed creates 10 billion of fresh new money to buy back the bonds.
The bonds are destroyed and forgotten about.
The government debt is now zero.

Scenario B:
The government create 10billion of bonds and sells them to
the private sector.
The government debt is now 10 billion.
Then the fed creates 10 billion of fresh new money to buy back the bonds.
The bonds are retained and are still “active”.
The government debt is still 10billion - but the debt is to its central
bank. (rather like your left hand owing your right hand money!)

Actually, the last step in scenario B may not be so silly after all. It effectively acts as a commitment being made to the outside world that 10billion of base money will be destroyed at some future time thereby giving people confidence in the value of the currency - or other/subsequent government bonds.

So which one is the case A or B? (or some thing else entirely?).

2

I cannot say for all countries, but usually it’s B.

See, e.g.,

Federal Reserve US Treasury Holdings Pass The $1 Trillion Mark

3

It’s B.

The magic of the banking cartel + government partnership (i.e. The Federal Reserve System):

  1. The government gets to “borrow” (and spend) without paying any interest (as all the interest it pays the Fed, is given back to the treasury).

  2. The banking cartel gets to create $10B which through fractional reserve becomes $100B out of thin air on which it’s members “earn” interest (profit!?).

Match made in heaven.

Z.

4

Thanks for your quick replies.

Re: "1. The government gets to “borrow” (and spend) without paying any interest (as all the interest it pays the Fed, is given back to the treasury). " - hang on a second - presumably the whole point is that money paid in coupon or principal to the fed from the treasury (by virtue of the fact that the fed holds the bonds) must be destroyed - i.e. taken out of circulation altogether.

5

All Fed’s profits (revenue minus costs) are paid to the treasury, I think annually. So, to answer your question, no, the interest the treasury “pays” the Fed doesn’t get “destroyed”. That interest is a part of Fed’s revenue, hence a part of Fed’s profits that are forwarded to the treasury.

6

By statute, the Treasury must use all the interest payments received from the Fed to pay back and retire some of the government debt; however, the Treasury issues more debt than it retires, so the debt will increase over time.

The Fed does not apply the interest payments against the principal.

However, if the Treasury pays the government bond on the Fed balance sheet in full (the bond matures), presumably, the bond is retired and ceases to exist, and the an equivalent amount of Federal Reserve Notes is also retired and ceases to exist.

7

I would add:

  1. The government can sell the bonds even if noone really wants to buy - the CB creates the artificial demand.
8

“However, if the Treasury pays the government bond on the Fed balance sheet in full (the bond matures), presumably, the bond is retired and ceases to exist, and the an equivalent amount of Federal Reserve Notes is also retired and ceases to exist.”

I don’t think there’s a one to one relationship between Federal Reserve Notes & the notional value of the bonds. I may be wrong, but I thought the actual physical paper notes were a small fraction of the electronic dollars out there.

9

This is true, in the sense any Fed purchase of a bond is not recorded at the face value, but at the market value at the time of purchase. For example, if the Fed buys a bond with a face value of $10,000, but at a market price of $10,100, then the bond will be recorded at the Fed books at cost at $10,100.

Because of accounting principles, the premium of $100 dollars ($10,100 - $10,000) should be amortized over time, until the recorded value of the bond is reduced to exactly $10,000.

Then when the bond matures, the Treasury, in theory, can take $10,000 in Federal Reserve Notes, and demand the bond back. The Fed takes the $10,000 Federal Reserve Notes and retires those notes, and the Treasury takes the bond and retires it.

In essense, the Treasury takes those Federal Reserve Notes and redeems them for assets on the Fed balance sheet.

If by one to one relationship you mean the Federal Reserves Notes are pegged to particular bonds, then the answer is no.

This is true. But the monetary base consists of the following:

Monetary Base = Paper Money + Coins + Electronic Dollars (member bank reserve deposits at the Fed)

The whole monetary base are Federal Reserve Notes and coins (either electronic or physical), which is distinct from bank money. In other words, Federal Reserve Notes can either be in paper or digital form.

10

OK, what I meant by a one to one relationship is along the lines of $1 million in treasuries requires $1 million in physical paper dollars. Under that scenario if you issue another $50 Billion in Treasuries you would issue another $50 billion in paper currency, and if you retire $50 Billion in treasuries you would need to retire $50 billion in FRN. I was under the impression that wasn’t the case, but rather that the paper notes were a relatively small fraction of the treasuries or even of all the M1 money supply out there. I figured they were related, that as the money supply increased, the paper currency would need to increase in roughly the same proportion, such as 20% or whatever, depending upon the public demand for paper currency.

That is why I was wondering if paper currency necessarily had to be retired when the treasuries were as proposed in the original post. I would have guessed that they wouldn’t necessarily do so, but would rather keep an eye on the overall money supply and just keep on retiring and issuing bonds to fit their perceived needs.

11

No. The Federal Reserve owns approximately 7% of the total Federal debt, which was purchased with base money (Federal Reserve Notes). The remainder 93% would have to be purchased with bank money (e.g., demand deposits from private banks).

Base money are Federal Reserve Notes deposited by banks as reserves at the Federal Reserve or held as paper currency in bank vaults. These Federal Reserve Notes can be paper or digital. In practice, the Fed purchases Treasury debt with digital currency.

The Treasury issues the $50 billion government debt, which the public buys on the open market.

There is no need for the Fed to issue another $50 billion to finance the additional government debt, since the purchase can be financed with existing money, by private investors, moved from private accounts to the Treasury.

If the Fed chooses to buy the $50 billion in government debt, it can purchase those securities on the open market, from private investors, with additional Federal Reserve Notes.

If a government bond is owned by a private person, and it matures, then the principal can be paid by the Treasury from existing money. The Treasury retires that particular bond, which ceases to exists.

But the money paid by the Treasury still continues to exist, as money held by a private person.

If a government bond is owned by the Federal Reserve, and it matures, then the process can be somewhat murky, or perhaps convoluted.

But ultimately, the government bond is retired, and an equivalent amount in Federal Reserve Notes are also retired and ceases to exist.

Yes.

No. If the demand for paper currency remains the same, money supply can still increase, without an increase in the paper currency. This is because the money, other than paper, exists either as Federal Reserve Notes in digital form or as fractional reserve bank money.

The Federal Reserve Notes are retired (ceases to exist) when the Fed sells government bonds on the open market, or returns the government bond to the Treasury upon maturity. In either case, there is a monetary contraction of the money supply.