Why does the money supply in an economy increase when a government sells securities to the banking sector?
Posted on November 9th, 2009 by admin
Banking
And why is the money supply not altered when the government borrows from the private sector?
And why is the money supply not altered when the government borrows from the private sector?
If so, then what are the changes?
Please explain in detail.
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Filed under: Economics
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When the govt. sells already issued securities to the banks, it only mops of liquidity from the banks and therefore money supply should decrease The same thing happens when the Govt. borrows from the private sector: money supply should decrease.
But something else happens in the case of ne security issues by the Govt.. New issues of govt securities are first given to the central bank and the central bank just credit the govt’s accounts with the banks by the same amount. Thus the deposit base of the banking system increases along with banks’ reserves with the central bank. So money supply increases first. Then, when the Govt starts spending from the deposits, money starts circulating. If the securities are sold direct to the private commercial / household sector (other than banks), the bank deposits just get transfered from private accounts to govt. accounts without affecting the reserves the banks keep with the Central Bank. So, this is the difference you are looking for. If the banks were to directly purchase govt. securities without the routing through the Central Ban the same thing would have happened: transfer of banks’ deposits from their accounts with the central bank to the govt account with the banks.
For open market operations, see wikipedia below:
Open market operations are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation.
Since most money is now in the form of electronic records, rather than paper records such as banknotes, open market operations are conducted simply by electronically increasing or decreasing the amount of money that a bank has, e.g., in its reserve account at the central bank, in exchange for the bank selling or buying a financial instrument. Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells these assets in the open market, the amount of money that the bank holds decreases, effectively destroying money.
The process does not literally require the immediate printing of new currency. A central bank account for a member bank can simply be increased electronically. However this will increase the central bank’s requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance.
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First, the money supply increases when the government BUYS securities from the banking sector.
Now, there are two different government departments involved in your question. One is the Federal Reserve (FED), the other is the Treasury.
When the FED buys bonds from banks it pays them with money. Where does the FED get the money from. It just prints it. Technically, the money isn’t even printed its just created in an account. The FED then uses its newly created money to buys bonds which puts the money in the hands of banks.
The reason the FED buys bonds is so that its not in the position of just giving away the money to someone. That wouldn’t seem fair. So it buys government bonds which is sort of like giving the money to the Treasury.
This is a good segue to the second part of your question.
What happens when the Treasury borrows money from private sector. In this case citizens simply give their money to the Treasury and the Treasury turns around and spends it on something else. The money stays in circulation.
Now what would happen in the FED sold securities to the banking sector?
Well the banks would pay the FED money for its securities. Then the FED would turn around and tear the money up. They simply destroy the money the get when they sell things and print new money when they want to buy things.
As you can see the FED is extremely powerful.