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I know that when the Federal Reserve buys Treasury bonds it increases the money supply, but I don't understand the process behind it. The model that I have given below (which is my best understanding of open market operations) is wrong and I need help understanding why.

Suppose the US Government through the Treasury issues a \$100 bond with a yield of \$110. A third party purchases the bond and later sells it to the Federal Reserve for $105 during open market operations. Before the maturity date, the balance of the US Government is \$100, third party \$5, and Federal Reserve -\$105. At the maturity date, the balance of the US Government is -\$10, third party \$5, and Federal Reserve \$5.

This model erroneously depicts a zero sum transaction and not an increase in the money supply.

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When we talk about the money supply, we are often referring to credit that is circulating in the economy at a moment in time. In other words, the more assets the Federal Reserve takes on, the more the money supply will increase at that moment. Indeed if the Federal Reserve decided to reduce its balance sheet by letting treasuries mature and the US treasury absorbed an equivalent amount in taxes to pay off its debt, the money supply will shrink back to where it started before the government issued those treasuries. But that will be far into the future if it even ever happens, and so for the present time open market operations do nominally increase the money supply.

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  • $\begingroup$ Is the money supply directly proportional to the public debt then? Can the money supply increase or decrease without changing the public debt? $\endgroup$ – mrhumanzee Sep 20 '19 at 11:14
  • $\begingroup$ Banks can create credit through loans. See en.wikipedia.org/wiki/Fractional-reserve_banking $\endgroup$ – Kent Shikama Sep 20 '19 at 11:31

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