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I just read parts of an introductory economics book. I read about the monetary system in the U.S. and came up with the following question:

Can the Fed raise the M1 money supply permanently without having either to buy further Treasury bills or use helicopter money (i.e. to refrain from recieving the principal payment at maturity) ?

I think about the following model:

There is the Fed $F$ the companies $C$ the households $H$ and the banks $B$. We can partition the system into $\{F\}$ and $\{B,C,H\}$. At time $t=0$ there are $\alpha$ $\$$ in $\{B,C,H\}$ as currency i.e. as physical bank notes. No matter what happens in $\{B,C,H\}$ $\alpha$ cannot increase. Suppose $F$ wants to increase the money supply. As far as I know the Fed primarily uses open market operations (OMOs) to increase money supply. Let's try this. To simplify things let's consider a very simple bond. Someone in $\{B,C,H\}$ issues a bond for $\beta \$ $. The terms of the bond will grant the buyer a payment of $\gamma \$ $ at $t=1$ and $ \delta = \gamma - \beta > 0$.

So, as the Fed wants to increase money supply it undergoes an OMO, i.e. prints $\beta \$ $ and buys our bond. The money supply in $\{B,C,H\}$ at $ 0 < t <1 $ is $ \alpha + \beta $. So far so good. We could consider the money multiplication buy loans during $ 0 < t <1 $ but that would not change the situation at $ t > 1$. At $t=1$ the issuer of the bond i.e. someone in $ \{B,C,H\}$ has to pay $F$ $\gamma \$$. So, at $t > 1 $ there is less money ( $ \alpha - \delta$ ) in $\{B,C,H\}$.

So, to me all of that seems controversial. $F$ wants to increase the money in $\{B,C,H\}$ but effectively reduces it. Of course $F$ could disguise the situation by buying another bonds and thus increase the time until maturity but this does not really change the situation. So, this question comes up:

Can the Fed raise the M1 money supply permanently without having either to buy further Treasury bills or use helicopter money (i.e. to refrain from recieving the principal payment at maturity) ?

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  • $\begingroup$ Hi, in the question, you ask about M1 (which includes bank deposits), but the description of “money supply” that you use in the question is probably closer to the monetary base (M0). Since M1 is larger than the monetary base, we could run into the situation where M1 falls, while the monetary base rises. This greatly complicates the answer if you really want M1. $\endgroup$ – Brian Romanchuk Aug 29 '18 at 18:13
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I am going to just discuss the situation for the monetary base, not M1. It is possible that the monetary base and M1 could move in opposite directions.

The following three instruments are the main components of the monetary base.

  1. Currency in circulation: dollar bills, and coins. Currency holdings are the result of voluntary decisions by the private sector, and the Fed has very limited ability to influence those decisions.
  2. Required reserves of banks held at the Fed. In order to increase this, loan amounts outstanding must increase. One can argue that Fed decisions influence borrowing decisions, but it is not something that they can easily directly control. (We would need to go back to the Volcker Fed to see a historical attempt to do this; its effectiveness has been debated. Sorry. no reference handy.)
  3. Bank settlement balances in excess of required reserves (excess reserves). These balances went from near zero to being quite large as a result of “quantitative easing.”

The Fed cannot drive excess balances negative, as that would imply that some banks are short reserves - which is not allowed by regulators. However, it is free to make excess reserves as positive as they wish, as quantitative easing proved.

They do this via:

  • buying something;
  • or lending against something (which includes repurchase agreements, or repos).

That “something” is usually Treasury securities, but there are classes of private debt securities is can buy or lend against (as was done in the Financial Crisis). There is no other choice; the Fed does not have a legal mandate to dump money from helicopters (or whatever). So the answer to your question is that they essentially need to buy enough Treasury bills/bonds to increase the monetary base, unless they want to lend against other private debts.

I am not able to give a legal opinion, but it is unclear that the Fed has the ability to not demand payment for matured bonds/bills. Even if they did so, it would just be an irregular loan to the Treasury. (Since Fed profits are returned to te Treasury anyway, there is no point not taking the contractual Treasury payments.)

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