Page 306 - Krugmans Economics for AP Text Book_Neat

lending, and the money supply increases via the money multiplier. If the Fed increases
An open -market operation is a purchase
the spread between the discount rate and the federal funds rate, bank lending falls—
or sale of government debt by the Fed.
and so will the money supply via the money multiplier.
The Fed normally doesn’t use the discount rate to actively manage the money sup-
ply. Although, as we mentioned earlier, there was a temporary surge in lending
through the discount window in 2007 in response to a financial crisis. Today, normal
monetary policy is conducted almost exclusively using the Fed’s third policy tool:
open -market operations.

Open-Market Operations

Like the banks it oversees, the Federal Reserve has assets and liabilities. The Fed’s assets
consist of its holdings of debt issued by the U.S. government, mainly short -term U.S.
government bonds with a maturity of less than one year, known as U.S. Treasury bills.
Remember, the Fed isn’t exactly part of the U.S. government, so U.S. Treasury bills held
by the Fed are a liability of the government but an asset of the Fed. The Fed’s liabilities
consist of currency in circulation and bank reserves. Figure 27.1 summarizes the nor-
mal assets and liabilities of the Fed in the form of a T-account.

figure 27.1

The Federal Reserve’s Assets Assets Liabilities
and Liabilities
Government debt Monetary base
The Federal Reserve holds its assets mostly in (Treasury bills) (Currency in circulation
short -term government bonds called U.S. Treas- + bank reserves)
ury bills. Its liabilities are the monetary base—
currency in circulation plus bank reserves.

In an open -market operation the Federal Reserve buys or sells U.S. Treasury
bills, normally through a transaction with commercial banks—banks that mainly
make business loans, as opposed to home loans. The Fed never buys U.S. Treasury
bills directly from the federal government. There’s a good reason for this: when a
central bank buys government debt directly from the government, it is lending di-
rectly to the government—in effect, the central bank is issuing “printing money” to
finance the government’s budget deficit. As we’ll see later in the book, this has his-
torically been a formula for disastrous levels of inflation.
The two panels of Figure 27.2 show the changes in the financial position of both
the Fed and commercial banks that result from open -market operations. When the
Fed buys U.S. Treasury bills from a commercial bank, it pays by crediting the bank’s
reserve account by an amount equal to the value of the Treasury bills. This is illus-
trated in panel (a): the Fed buys $100 million of U.S. Treasury bills from commercial
banks, which increases the monetary base by $100 million because it increases bank
reserves by $100 million. When the Fed sells U.S. Treasury bills to commercial banks,
it debits the banks’ accounts, reducing their reserves. This is shown in panel (b), where
the Fed sells $100 million of U.S. Treasury bills. Here, bank reserves and the monetary
base decrease.
You might wonder where the Fed gets the funds to purchase U.S. Treasury bills
from banks. The answer is that it simply creates them with a stroke of the pen—or,
these days, a click of the mouse—that credits the banks’ accounts with extra reserves.
(The Fed issues currency to pay for Treasury bills only when banks want the addi-
tional reserves in the form of currency.) Remember, the modern dollar is fiat money,
which isn’t backed by anything. So the Fed can create additional monetary base at its
own discretion.
264 section 5 The Financial Sector