1303135368427_Chapter17_Instructor_Notes - CHAPTER 17: THE...

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______________________________________________________________________________________ 345 CHAPTER 17: THE CENTRAL BANK BALANCE SHEET AND THE MONEY SUPPLY PROCESS A. T HE B ASICS This chapter provides substantial detail about the balance sheet of a central bank and how specific policy actions change the value of the assets, or the “size,” of the balance sheet. In principle, these actions include open market operations, foreign exchange interventions, and discount loans to banks. In practice, though, most monetary policy is implemented through open market operations, the process by which the central bank buys and sells government securities with banks. In the U.S., foreign exchange interventions are rare, with the value of the U.S. dollar determined primarily by supply and demand forces in the foreign exchange market. And while loans to banks can be extremely important in key circumstances (see this chapter’s Applying the Concept : The Fed’s Response on September 11, 2001 on text page 434), normally the volume of loans is measured in a few hundred million, rather than billions of, dollars. The second section of the chapter, Changing the Size and Composition of the Balance Sheet, discusses the mechanics of how the Fed engages in open market operations and what it buys and sells. In this regard, you are applying Core Principle 4, that markets allocate resources and determine prices. While not the explicit focus here, you should recall from chapter 6 that these actions affect the quantity and price (and hence the interest rate) of these securities. Later parts of the chapter present, with increasingly realistic detail (sorry, but that means more complexity) the implications of these open market operations for the money supply. And ultimately, the Fed is engaging in these open market operations to affect the stability of not only the financial market, but the economy as a whole. So, the discussion here is ultimately aimed at Core Principle 5: stability enhances economic welfare. In fact, between now and the end of the text, the aim is to describe explicitly what policy can, and can’t, do to affect economic well-being. This chapter and the next help set the stage. Finally, as you read about the Fed’s balance sheet, pay attention to an important detail about open market operations. When it buys a security from a bank in an open market operation, notice how the Fed pays for it. All it does is credit the bank’s reserve account at the Fed. That is, out of thin air, the Fed creates money. In chapter 2, you learned about fiat money, the fact that our dollar bills have no commodity backing, but rather are money by decree. That the Fed can simply pay for purchases of government securities it buys in the open market with a figurative stroke of a pen (or, literally, a few strokes of a keyboard) adding “money” to the accounts of banks at the Fed is a powerful example of fiat money. The Fed can buy billions and billions of dollars of government bonds in the open market and “pay” for them simply by crediting bank reserve accounts on a computer.
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1303135368427_Chapter17_Instructor_Notes - CHAPTER 17: THE...

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