Three Fed tools: reserve requirement, interest rate on loans to member banks, & open market operations.
How does the Fed make the money supply grow at x% per year. Since the first two can only go so low, it can’t be them. But to be the third, purchasing bonds, isn’t it just issuing bonds it has already sold, netting zero effect? Or is it buying up bonds that the treasury has issued to pay for yearly deficits, in which case the Fed couldn’t increase the money supply over time if the federal government carried no debt?
The main monetary tool for the federal resrve board is “open market operations”. The New York Federal Reserve bank intervenes in the market for government bonds. If the Fed wants to increase the money supply, it buys bonds from banks, converting the bond into money that a bank can lend. If the Fed wants to decrease the money supply it sells bonds to banks, absorbing money.
My problem is that I’m blanking on how they do that year after year. If the money supply is growing at, let’s say, 3% per year, then the open market operations have to be buying more bonds than it sells every year. So the Fed is a net purchaser of bonds year in and year out.
Where are all these bonds coming from? Are they buying bonds that the treasury has issued to cover deficits? If, and this is strictly hypothetical, the federal gov’t. carried no debt whatsoever, what bonds would the Fed buy to carry out this money supply expansion?
The short-term operations make perfect sense. It’s the long-term that has me pickled right now. I think.
It’s the latter. The Fed is creating money to buy up Treasury debt. Treasury accounts are part of the money supply while the Fed’s accounts are not. So when the Treasury issues bonds/note/bills, the money received is still part of the money supply. The Fed also returns most of the interest it receives on Federal debt to the Treasury.
If the federal government had no debt, open market operations would be alot trickier (and indeed has been). The Fed would have to look to other debt instruments: foreign government debt, bank cds, interbank loans, commercial paper, etc… The main problem with these is credit risk, liquidity, and allegations of favoritism. It could be done; it has been done; but it certainly isn’t ideal. The fed could also loosen the regulations on what it accepted for collateral at the discount window.