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Let's say the Federal Reserve purchases a \$100 one-year Treasury bill from the market, and puts ~\$100 of cash into the economy. A year later, this T-bill comes due, and the Treasury pays the Fed $100. What happens with this cash?

I can imagine a few possibilities:

  • The money is immediately reinvested in new securities. Since no new money is created, the monetary base stays constant.
  • The money is destroyed, shrinking the monetary base.
  • The money is transferred to the Treasury as Fed revenue. Since this money (a Fed liability) is no longer backed by a security, the Fed's balance sheet goes into the red.

This question is motivated by this quote from the Wikipedia page on Debt Monetization:

The central bank may purchase government bonds by conducting an open market purchase, i.e. by increasing the monetary base through the money creation process. If government bonds that have come due are held by the central bank, the central bank will return any funds paid to it back to the treasury. Thus, the treasury may "borrow" money without needing to repay it. This process of financing government spending is called "monetizing the debt".

This seems to imply the third of my listed possibilities, but as mentioned this seems to break the promise that all Fed-issued money is backed by assets.

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Currently (Apr 2017) the Fed has a policy of reinvesting the proceeds of maturing securities in new securities, so the first option is true. However, the Fed is believed to be considering ending this reinvestment policy in the next few months. In that case, the second option will apply- the Fed's balance sheet will decrease and the overall money supply will decrease (assuming that the Treasury will then issue securities to keep its cash balance unchanged). Option 3 does not really apply because the maturity of a security held by the Fed is not 'revenue'. They would just reduce assets (Treasury bond) and l moiabilities (cash balance owed to the Treasury) at the same time.

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  • $\begingroup$ Very helpful, thanks. So then would you agree that the Wikipedia quote above is misleading/incorrect? $\endgroup$ – zplizzi May 2 '17 at 19:04
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The Treasury has a balance at the Federal Reserve; this balance is not part of the monetary base.

When the \$100 is paid back, the Treasury balance is run down by \$100, and the assets of the Fed (bill holdings) is reduced by $100. The Federal Reserve balance sheet remains in balance, and there is no effect on the monetary base.

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