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I'm trying to understand how open market operations work to reduce money supply.

So the Federal Reserve sells bonds... when this happens, the bank balances of the bond-purchasers goes down... the bank balance of the Federal reserve goes up.

So now what does the Federal reserve do with this money... is the money just eliminated from the system completely? Or does the Federal Reserve hold that money? Does it even make a difference... Thanks.

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    $\begingroup$ The Fed does not hold its money in banks, banks hold their (extra) money at the Fed (or, more accurately, at one of the Federal Reserve Banks). The Fed is a bank (well, a system of 12 of them). So when the Fed sells bonds to banks, their holdings of money decline, full stop. $\endgroup$
    – dismalscience
    Mar 23, 2020 at 20:05
  • $\begingroup$ So the recipient of the bonds has an account at a Fed bank... when the bond is issued, the balance of the bond recipient at the Fed bank goes down. And that's the end of it? So the money has gone out of the system completely as I understand it? $\endgroup$
    – Ameet Sharma
    Mar 23, 2020 at 20:27
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    $\begingroup$ Yes, as in Kent’s example, it’s just as though the Fed ripped up the “wash the house” coupon. The Fed’s balance sheet loses both bond assets and offsetting money liabilities. Their balance sheet shrinks. $\endgroup$
    – dismalscience
    Mar 23, 2020 at 20:32

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Have you ever gifted your parents a "I'll wash the house" ticket? Or maybe your parents just forced you to do it. In any case, money, or less colloquially a Federal Reserve note, is like a "I'll wash the house" ticket issued by the Federal Reserve. But instead of being able to redeem it for a house wash, you can redeem it to receive a certain amount of gold. That is if you lived pre-1971 (edit: pre-1933). Now you can't redeem it for anything, but it doesn't change the fact that Federal Reserve notes are a liability to the Federal Reserve.

So if your parents cash-in your "I'll wash the house" ticket, what will you do with the physical ticket? Store it as a souvenir? Rip it up? Re-gift it? Sell it to them in exchange for a new computer? I think "[d]oes it even make a difference" sums it up pretty well, especially since most of the "tickets" are digital not physical.

Footnote: The government guarantees you can pay taxes with Federal Reserve notes. So in that circular sense, Federal Reserve notes are redeemable for something.

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    $\begingroup$ 1933 might be a more accurate date than 1971 for US citizens for the ability to receive the specified amount of gold for Federal Reserve notes $\endgroup$
    – Henry
    Mar 23, 2020 at 15:56

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