The Mystery of Banking

174
The Mystery of Banking
the Fed buys $25 billion of old bonds on the open market; this
creates increased demand deposits in the banks of $25 billion,
matched by $25 billion in new reserves. Then, the Treasury issues
$100 billion of new bonds, which the banks now buy because of
their new reserves. Their total increase of new demand deposits
is $125 billion, precisely the money multiple pyramiding on top
of $25 billion of new reserves. The changes in the balance sheets
of the commercial banks and of the Fed are depicted in Figure
11.9. 
Commercial Banks
A
E & L
(new) U.S. Government
Demand deposits
securities
+ $100 billion
to government
bond dealers
+ $25 billion
Reserves
+ $25 billion
to the Treasury + $100 billion
Total assets
+ $125 billion
Total demand
deposits
+ $125 billion
Federal Reserve
A
E & L
(old) U.S. Government
Demand deposits
securities
+ $25 billion
to banks
+ $25 billion
F
IGURE
11.9 — F
ED
A
IDING
B
ANKS TO
F
INANCE
D
EFICITS
Thus, under the assumed conditions of a 20 percent reserve
requirement, the Fed would need to buy $25 billion of old bonds
to finance a Treasury deficit of $100 billion. The total increase in
the money supply of the entire operation would be $125 billion. 
If the Fed were to finance new Treasury bond issues directly,
as it was only allowed by law to do for a while during World War
Chapter Eleven.qxp 8/4/2008 11:38 AM Page 174

---

II, this step would be wildly inflationary. For the Treasury would
now have an increased $100 billion not just of newly-created
bank money, but of “high-powered” bank money—demand
deposits at the Fed. Then, as the Treasury spent the money, its
claims on the Fed would filter down to the private economy, and
total bank reserves would increase by $100 billion. The banking
system would then pyramid loans and deposits on top of that by
5:1 until the money supply increased by no less than $500 billion.
Hence we have the highly inflationary nature of direct Fed pur-
chases of new bonds from the Treasury. 
Figure 11.10 depicts the two steps of this process. In the first
step, Step 1, the Fed buys $100 billion of new government bonds,
and the Treasury gets increased demand deposits at the Fed. 
Step 1: Federal Reserve
Assets
Equity & Liabilities
(new) U.S. Government
Demand deposits
securities
+ $100 billion
to the Treasury + $100 billion
F
IGURE
11.10 — F
ED
P
URCHASE OF
N
EW
G
OVERNMENT
S
ECURITIES
Then, as the Treasury spends the new money, its checks on the
Fed will filter down toward various private sellers. The latter will
deposit these checks and acquire demand deposits at their banks;
and the banks will rush down and deposit the checks with the
Fed, thereby earning an increase in their reserve accounts. Figure
11.11 shows what happens in Step 2 at the end of this process. 
Thus, the upshot of the Fed’s direct purchase of the Treasury
deficit is for total bank reserves to rise by the same amount, and
for the Treasury account to get transferred into the reserves of the
banks. On top of these reserves, the banking system will pyramid
deposits 5:1 to a total increased money supply of $500 billion. 
Central Banking: The Process of Bank Credit Expansion
175
Chapter Eleven.qxp 8/4/2008 11:38 AM Page 175

---