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The Fed makes money through its open market operations. I am considering a scenario in which the Fed, instead of trying to achieve goals like controlling inflation, tries to maximize its profits in real terms.

What exactly would such a policy mean- would it be equivalent to the Fed targeting a certain variable like inflation or output? In the event of a supply or demand shock, what would the Fed do?

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  • $\begingroup$ Any profits the Federal Reserve makes is given to the Treasury, so they would never have any incentive to maximize profits. $\endgroup$ – DornerA May 10 '16 at 14:49
  • $\begingroup$ This is a hypothetical question- what if they did want to maximize their profits? $\endgroup$ – InquisitivePerson May 10 '16 at 15:21
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The Fed also conducts discount window borrowing. If pure profit maximising were the goal, they might only provide reserves through the discount window. They might even shake down weaker banks.

If confined to buying only Treasury securities, they would just need to maximise the real rate differential between currency and the nominal rate (plus, shrinking their balance sheet so that they no longer need to pay interest on reserves). The maximum level of the real policy rate that is sustainable depends upon your view of the natural rate of interest. If the belief is that the actual real policy rate cannot greatly depart from a natural rate, we would see little difference in policy.

Buying bonds and keeping rates low works to lock in profits once, but the profits will dry up as bonds mature, and are replaced by low-yielding ones.

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To maximize profits they could buy 4TN of securities and then keep Fed Funds low for ever. That would result in extracting interest income from the private sector, which one could argue is a contractionary policy. Of course this is what they actually did, although they have in fact started raising Fed Funds recently.

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