Financial Markets and Institutions (2-downloads)

375

Federal Reserve System

Assets

Liabilities

Foreign assets 

(international reserves)

–$1 billion

Currency in circulation

–$1 billion

Federal Reserve System

Assets

Liabilities

Foreign assets 

(international reserves)

–$1 billion

Deposits with the Fed

(reserves)

–$1 billion

Because the monetary base is made up of currency in circulation plus reserves, this

decline in currency implies that the monetary base has fallen by $1 billion.

If instead of paying for the foreign assets sold by the Fed with currency, the

persons buying the foreign assets pay for them with checks written on accounts at

domestic banks, then the Fed deducts the $1 billion from the reserve deposits it holds

for these banks. The result is that deposits with the Fed (reserves) decline by 

$1 billion, as shown in the following T-account:

In this case, the outcome of the Fed sale of foreign assets and the purchase of dol-

lar deposits is a $1 billion decline in reserves and, as before, a $1 billion decline in the

monetary base because reserves are also a component of the monetary base.

We now see that the outcome for the monetary base is exactly the same when

a central bank sells foreign assets to purchase domestic bank deposits or domestic

currency. This is why when we say that a central bank has purchased its domestic

currency, we do not have to distinguish whether it actually purchased currency or

bank deposits denominated in the domestic currency. We have thus reached an

important conclusion: A central bank’s purchase of domestic currency and