Financial Markets and Institutions (2-downloads)

leads to an expansion of reserves and deposits in the banking system and

hence to an expansion of the monetary base and the money supply.

Similar reasoning indicates that when a central bank conducts an open market sale,

the public pays for the bonds by writing a check that causes deposits and reserves in

the banking system to fall. Thus, an open market sale leads to a contraction of

reserves and deposits in the banking system and hence to a decline in the

monetary base and the money supply.

Discount Lending

Open market operations are not the only way the Federal Reserve can affect the amount

of reserves. Reserves are also changed when the Fed makes a discount loan to a bank.

For example, suppose that the Fed makes a $100 discount loan to the First National Bank.

The Fed then credits $100 to the bank’s reserve account. The effects on the balance

sheets of the banking system and the Fed are illustrated by the following T-accounts: