Central Bank Balance Sheets and foreign bonds

Question

I have a question relating to central bank's balance sheets, taken from Krugman and Obstfelds' "International Macroeconomics" textbook.

They mention that when the central bank purchases foreign bonds, the domestic money supply increases. This is paid for with domestic currency.

My question is: how does this look like in practice? So say the Fed buys the government of England's bonds. Will they convert it first to pounds? Or would Bank of England sell the bond for dollars? I am struggling to understand how the increase in purchase of foreign bonds increases domestic money supply.

Any help is much appreciated.

Answer 1

It happens in reality, pretty much as described in the book, not far from what you wrote

Say that the fed would like to buy UK bonds. Since UK bonds are issued in pounds, in order to buy them, the Fed will have to 1st buy pounds, in exchange for dollars, which didn't previously exists. In this case, more dollars will enter circulation, and the money supply will rise. In parallel, the dollar exchange rate will increase against the pound, that is the dollar will weaken.

Its the same logic that domestic bonds: buying domestic government bonds, in exchange for previously non-existing dollars, would increase money supply.

In today's free capital markets, there isn't any essential difference between the two, because of arbitrage: In the case of buying foreign bonds, and rising pound rate, euro holders, for example, for them rates remained unchanged , will buy dollars to sell pounds, until a new euro rate will be set.

Similarly, a local increase in inflation, due to purchasing domestic bonds, will effect exchange rates, as local currency value would fall.