Fed and the creation of money

schiavo

Hey,

I've read somewhere that the Fed controls the amount of money in the economy by, among other means, conducting open-market operations.
These operations involve the issue or purchase of bonds
The question is:
-When the Fed purchases bonds, does it pay them only by creating money, or does it use money from the Treasure?
-If the Fed creates money to purchase bonds, does it destroy money when issuing new bonds?

noodler

schiavo wrote: »

The question is:
-When the Fed purchases bonds, does it pay them only by creating money, or does it use money from the Treasure?

Central Banks don't carry out OMOs using Government revenues.

I mean imagine the ECB had directly used German tax revenue to purchase 70bn or so of Greek bonds?

schiavo wrote: »

The question is:
-If the Fed creates money to purchase bonds, does it destroy money when issuing new bonds?

I am not sure about this.

It depends on the purpose of the operation.

I mean the ECB purchased many Government bonds over the last 2 years with its SMP programme but these transactions were sterlilised (i.e. they did take the same amount of money out of the system). This is because the aim of the scheme was to alleviate the pressur on Sovereign Bond Yields - not to stimulate the Economy by increasing the Money supply.

On the otherhand, the recent LTROs by the ECB were not sterilised.

I expect the the majority of FED increases in the money supply are not sterilised.

freeze4real

I did a similar question for my economics assignment.

when they feds buy bonds the are taking part in an expansionary monetary policy. the money in supply increases shifting the LM curve to the right.

when the fed purchase bonds they are decreasing money in supply as the money used to pay for the bonds are kept in the reserve.

Noodler nice post could you please say the abbreviations as I and some posters might not be familiar with them.

noodler

freeze4real wrote: »

I did a similar question for my economics assignment.

when they feds buy bonds the are taking part in an expansionary monetary policy. the money in supply increases shifting the LM curve to the right.

when the fed purchase bonds they are decreasing money in supply as the money used to pay for the bonds are kept in the reserve.

Noodler nice post could you please the abbreviations as I and some posters might not be familiar with them.

Sure, the SMP is the Security Markets Programme - it is the name of the ECB's reluctant plan to purchase soversign bonds on the secondary market. It came into effect in May 2010 and although they have slowed their purchases dramatically of late, at the end of last week they held around 218bn of Government bonds (mainly Greek, Irish, Portugal Spain, Italy we presume). These purchases are sterlilised - the ECB takes in deposits in order to keep the MS constant.

The LTROs are even newer. First one was done in December, last on in March (or was it late Feb?). Unique as they lent to commercial banks in the Euro emergency liquidity at a three-year term (longer than usual for emergency liquidity). They have had a positive effect so far in terms of share prices and bond yields but unsure if they are actually encouraging banks to lend to small businesses etc.

Something like 1trillion has been given out in the LTROs. very roughly 500bn in each one. Some of this liquidity is not actually new though (some banks just switched shorter-term ECB loans for new 3-year ones). The LTROs are not sterilised.

schiavo

when the fed purchase bonds they are decreasing money in supply as the money used to pay for the bonds are kept in the reserve.

So, we can say that buying bonds is a non-reversible operation, because the government creates money to pay the bond sellers, but cannot destroy it in case it changes its mind.
Therefore the Fed can increase it's reserves at will, and does not need to be financed in any way to pay its internal debt.

Am I right?

noodler

schiavo wrote: »

So, we can say that buying bonds is a non-reversible operation, because the government creates money to pay the bond sellers, but cannot destroy it in case it changes its mind.
Therefore the Fed can increase it's reserves at will, and does not need to be financed in any way to pay its internal debt.

Am I right?

Reversible in what way?

I mean the point of inflationary monetary policy is self-evident. If they decide they want to slowdown the economy in a few years then they can always sell Government bonds are take in deposits to do so.

A central bank does not need to be financed in order to create money though (thats the whole point of a CB). Their balance sheet obviously changes though.

schiavo

It would not be reversible because, as stated, the Fed creates money by purchasing bonds, it cannot destroy that money when it issues bonds, the money stays on its reserves.

A central bank does not need to be financed in order to create money though (thats the whole point of a CB)

So, the central bank can create money at will?

noodler

schiavo wrote: »

It would not be reversible because, as stated, the Fed creates money by purchasing bonds, it cannot destroy that money when it issues bonds, the money stays on its reserves.

Well they could sell other bonds and reduce the money supply that way?

schiavo wrote: »

So, the central bank can create money at will?

At will is extreme but yes.

schiavo

Well they could sell other bonds and reduce the money supply that way?

Although they still can reduce the money supply by selling bonds, the creation of money still seems to irreversible.

Let me show you an example

In the beginning, there were X dollars in the world

Through OMO, the government created money to purchase some bonds. This creation accounted for 2000 dollars, now in the hands of investors. The current amount of dollars in the economy, at the moment, is X+2000

The government then changes its mind and thinks that 2000 more dollars in the economy will lead to inflation. It issues 2000 in bonds.

Although the government took 2000 dollars for itself, there are still X+2000 dollars in the economy, since the Fed does not destroy money in OMO's. The dollar is then permanently, irreversibly devaluated.

I

noodler

schiavo wrote: »

Although they still can reduce the money supply by selling bonds, the creation of money still seems to irreversible.

Let me show you an example

In the beginning, there were X dollars in the world

Through OMO, the government created money to purchase some bonds. This creation accounted for 2000 dollars, now in the hands of investors. The current amount of dollars in the economy, at the moment, is X+2000

The government then changes its mind and thinks that 2000 more dollars in the economy will lead to inflation. It issues 2000 in bonds.

Although the government took 2000 dollars for itself, there are still X+2000 dollars in the economy, since the Fed does not destroy money in OMO's. The dollar is then permanently, irreversibly devaluated.

I

I don't really get what you mean.

The 2000 they took out of the economy isn't technically in the money supply though?

schiavo

It may be not, as it is in the government's reserves but still, is affecting the value of the dollar. If the government prints dollars and keep them for itself, the value of the dollar is still affected (goes down) , isn't it?

noodler

schiavo wrote: »

It may be not, as it is in the government's reserves but still, is affecting the value of the dollar. If the government prints dollars and keep them for itself, the value of the dollar is still affected (goes down) , isn't it?

If said dollars aren't actually in the MS then I can't see how they would affect the exchange rate.

Bit shady on that though.

schiavo

Oh, really? Sorry, I didn't know that. I though dollars in the government's hand would also affect the exchange rate.

But, if:

-The government can print dollars at will
-The dollars created, if kept by the government, will bear no negative impact on the exchange rate.

Then why does the government need taxes? It can print money!

noodler

schiavo wrote: »

Oh, really? Sorry, I didn't know that. I though dollars in the government's hand would also affect the exchange rate.

But, if:

-The government can print dollars at will
-The dollars created, if kept by the government, will bear no negative impact on the exchange rate.

Then why does the government need taxes? It can print money!

Sorry, I think I see the source of our confusion now.

The FED does NOT EQUAL the Government.

It is independent.

The Government is not the one who prints the money, it is the autonomous Central Bank.

schiavo

So the Fed:

-does not collect taxes
-does not issue T-bills
-can finance any project by printing dollars (but, by doing so, puts the value of the currency at the stake)

And the goverment:

-has it's own budget for financing its projects


Am I right?

freeze4real

I'm not sure but the fed controls monetary policy while government controls fiscal policy.

noodler

schiavo wrote: »

So the Fed:

-does not collect taxes
-does not issue T-bills
-can finance any project by printing dollars (but, by doing so, puts the value of the currency at the stake)

And the goverment:

-has it's own budget for financing its projects


Am I right?

FED - Monetary Policy

Treasury - Fiscal (tax collection)

http://www.investopedia.com/articles/economics/08/treasury-fed-reserve.asp#axzz1qGRga8km


Maybe an example close to home would help you?

DoF: Raises tax and decides general fiscal Policy

NTMA: Issues Ireland's bonds

CBI: Is Ireland's indpendent central bank (although in reality much of the control is ceded to the ECB as per the Monetray Union).

In America the Treasury also issues US Gov bonds.