multiplier of bank loans and deposits, and hence of the total
money supply.
Therefore, if open market purchases of assets by the Fed are
a
factor of increase
of
reserves by the same amount, the other side
of the coin is that open market sales of assets are a
factor of
decrease
.
From the point of view of the money supply it doesn’t make
any difference
what
asset
the Fed buys; the only thing that mat-
ters is the Fed’s writing of a check, or someone writing the Fed a
check. And, indeed, under the Monetary Control Act of 1980, the
Fed now has unlimited power to buy any asset it wishes and up to
any amount—whether it be corporate stocks, bonds, or foreign
currency. But until now virtually the only asset the Fed has sys-
tematically bought and sold has been U.S. government securities.
Every week, the System Manager (a vice president of the Federal
Reserve Bank of New York) buys or sells U.S.
government securi-
ties from or to a handful of top private dealers in government
securities. The System Manager acts under the orders of the Fed’s
Federal Open Market Committee, which meets every month to
issue directives for the month. The Fed’s System Manager mostly
buys, but also sells, an enormous amount, and every year the
accumulated purchases of U.S. Treasury bills and bonds drive up
bank reserves by the same amount, and thereby act to fix total
reserves wherever the Fed wishes, and hence to determine the
total money supply issued by the banks.
One reason for selecting government bonds as the major asset
is that it is by far the biggest and most liquid capital market in the
country. There is never any problem of illiquidity, or problem of
making a purchase or sale in the government securities market.
How Fed open market purchases have been the driving force
of monetary expansion may be quickly
seen by noting that the
Fed’s assets of U.S. government securities, totaling $128 billion in
January 1982, was by far the bulk of its total assets. Moreover,
this figure contrasts with $62 billion owned in 1970, and $27 bil-
lion owned in 1960. This is roughly a 17 percent (uncompounded)
Central Banking: Determining Total Reserves
157
Chapter Ten.qxp 8/4/2008 11:38 AM Page 157
annual increase in U.S. government securities owned by the Fed
over the past two decades. There is no need to worry about the
ever-shifting definition of money, the ever-greater numbers of Ms.
All that need be done to stop inflation in its tracks forever is to
pass a law ordering the Fed
never to buy any more assets, ever
again. Repeatedly, governments have distracted attention from
their own guilt for inflation, and scapegoated various groups and
institutions on the market. Repeatedly, they have tried and failed
to combat inflation by freezing wages and prices, equivalent to
holding down the mercury column
of a thermometer by brute
force in order to cure a fever. But all that need be done is one
freeze that governments have never agreed to: freezing the Cen-
tral Bank. Better to abolish central banking altogether, but if that
cannot be accomplished, then, as a transitional step, the Central
Bank should be frozen, and prevented
from making further loans
or especially open market purchases. Period.
Let us see how a government bond purchase by the Fed on the
open market increases reserves by the same amount. Suppose that
the Fed’s System Manager buys $1,000,000 of government bonds
from private bond dealers. (Note that these are
not
newly issued
bonds, but old bonds previously issued by the Treasury, and pur-
chased by individuals,
corporations, or financial institutions.
There is a flourishing market for old government securities.) In
Figure 10.9, we show the System Manager’s purchase of
$1,000,000 in government bonds from the securities dealer firm
of Jones & Co. The Fed pays for the bonds by writing a check for
$1,000,000 upon itself. Its assets increase by $1,000,000, bal-
anced by its liabilities of newly-created deposit money consisting
of a check upon itself. Jones & Co. has only one option: to
deposit the check in a commercial bank. If it deposits the check at
Citibank, it now has an increase of its own money supply of
$1,000,000. Citibank then takes the check to the Fed, deposits it
there, and in turn acquires a new reserve of $1,000,000, upon
which the banking system pyramids
reserves in accordance with
the money multiplier.
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