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Suppose the Fed buys 1000 dollars worth of T-Bills in the open market to try decrease interest rates and increase the money supply. It does this by printing money and electronically increasing the sellers (a private bank) reserves by 1000 in exchange for the T-Bill thus boosting the private banks reserves and in this way the newly printed money has entered into the economy. Once the banks reserves have increased, the money multiplier process begins and the ultimate increase in the money supply is equal to 1000 dollars times the money multiplier. Depending on the money multiplier (that is, how willing banks are to lend that new money), the increase to the money supply could be only $1000 (in the case of no lending) or potentially a lot more. This much I understand as most textbooks describe the process fully.

But now what does the Fed end up doing with these T-Bills? Since they are T-Bills, they must mature within a year, so when they mature surely the government has to pay the Fed the face value of the T-Bill? The money the government uses to pay the Fed will then leave the economy and the money supply will not have changed ultimately. Even if the initial Fed purchase of the T-Bill had a high money multiplier and thus caused an increase in the money supply much larger than 1000, the government must pay the Fed with real currency or reserves at maturity. Thus, through open market operations, I can only reason that the money supply can increase at best only in the short term (maximum of 1 year when the last purchased T-Bills mature) and hence it does not constitute a permanent increase in the money supply. Also, when the government pays the Fed at maturity, this decrease in the money supply should lead to some deflation counteracting the initial boost that the open market operations were intended to do. So am I missing something or can open market operations only increase the money supply in the short term (being max 1 year assuming the Fed is purchasing T-Bills)? This reasoning would lead me to believe that quantitative easing can also only increase the money supply until the maturity date of the purchased government bonds (around 20 years) at which point the money supply must decrease to where it was before the quantitative easing began?

Any help on this would be most appreciated as all my textbooks describe how the Fed buys T-Bills and how this increases the money but not what the Fed ultimately does with these T-Bills and how that may or may not decrease the money supply.

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  • $\begingroup$ I have the same question. Disappointed this doesn't have more answers. $\endgroup$ – Scooter May 1 at 9:17
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If these T-bills mature and are repaid then you are correct money supply will decrease. In fact that might be desirable. Just because central bank wants to increase money supply in one year that does not mean they will not want to decrease it at some further period.

When the T-bill matures central bank also have option to then buy new T-bill to replace the old one if they want to keep money supply constant.

Lastly, central banks could also retire the T-bill meaning government never needs to repay it and the increase in money supply is now permanent (or more precisely there might be some other ways how it can be decreased but not anymore through the same instrument so if we are talking only about OMO's it would be permanent). This is possible but given that it is permanent and central banks might want to not just increase money supply but also decrease it in the future they might prefer just buy new bonds as old ones expire until they decide that they want to decrease money supply.

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  • $\begingroup$ Thanks, okay I think I understand. However looking at the inflation rate over the years, I see an average increase in prices of around 2.5% over the last 10 years. Since money velocity is relatively stable and real GDP has grown at roughly 2.5% per annum over these 10 years, there would have to be an increase in the money supply of around 5% year on year to sustain this. So what is driving this inflation? Does the Fed simply ensure that it possesses a greater value of Treasuries each year such that the money supply increases by roughly 5% and hence inflation ends up being roughly 2.5%? $\endgroup$ – SalahTheGoat Jan 1 at 14:48
  • $\begingroup$ @SalahTheGoat well empirically they do increase money supply over time - that is something that can even be empirically verified, and money supply can be increased by various other ways not just increasing base money but also by reducing reserve requirement that increases multiplier or by changing funds rate. But when it comes to OMOs they usually don’t make that money stock increase permanent. I mean even if you would want to increase money supply every year for foreseeable future why wouldn’t you give yourself option of decreasing it - it’s not like renewing debt is costly or inconvenient. $\endgroup$ – 1muflon1 Jan 1 at 14:53
  • $\begingroup$ I am having trouble finding anything that talks about the Federal Reserve "retiring its debts" Not saying it doesn't happen, just that can't find it mentioned. $\endgroup$ – Scooter Jun 16 at 4:23
  • $\begingroup$ @Scooter it’s not it’s debt it’s government debt. It’s rare to do that because typically central banks do not want to make permanent increases in money supply, I can’t think of any examples of fed doing that in recent history, but in developing countries central banks do that more often $\endgroup$ – 1muflon1 Jun 16 at 12:41
  • $\begingroup$ Yes, I meant that it was not requiring the debt it holds to be repaid. But if it doesn't do that - it would seem that the only way to increase the money supply would be for the Federal Reserve to buy and hold an ever increasing amount of bonds that were paid for by newly created money. $\endgroup$ – Scooter Jun 17 at 22:26

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