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I'm trying to understand how the Federal Reserve manages the money supply via open market operations. According to this post, when Fed buys securities, that increases bank reserves, which allows banks to lend more money, which increases the money supply. That makes sense. But when the issuer pays off the bond, wouldn't that reduce bank reserves, thus reducing lending, thus reducing the money supply? It seems like the overall effect of bond buying would be to increase the money supply in the short term but in the long term there may be a slight reduction in the money supply if the bond is paid back with interest.

Please let me know what I'm misunderstanding here. Thanks!

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  • $\begingroup$ Re: "increases bank reserves, which allows banks to lend more money, " - it is a very common misconception that bond buying (QE) only adds to the money supply when banks lend out the reserves but in fact the money gets to the real economy without any new lending having taken place. More here (this post addresses other aspects of your question too): mickanomics.blogspot.com/2021/03/… $\endgroup$
    – Mick
    May 18 at 16:29
  • $\begingroup$ This is fantastic! Thanks $\endgroup$
    – kjmerf
    May 19 at 16:43
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How the Federal Reserve Manages Money Supply?

Federal reserve manages money supply in various different ways (see Blanchard et al Macroeconomics ch4). The main ones are:

  • By managing interest rates on a reserves: lower interest rate reserves allow banks to lend more and expand money supply and vice versa.
  • By open market operations: where purchase Fed purchases debt in exchange for new money (which eventually increases reserves as that money finds it way to banks). Issuing new debt increases money supply and repayment of the debt decreases it.
  • By changing reserve requirement. Currently they are abolished by Fed, but nothing prevents Fed from bringing them back if they desire so. Here higher reserve requirement contracts money supply and lower one expands it.
  • Other: Fed can also affect money supply through other means such as banking regulation, although that is too broad of a topic to discuss in detail in one SE post. You can find some explanation of that in McLeay et al (2014) and sources cited therein.

But when the issuer pays off the bond, wouldn't that reduce bank reserves, thus reducing lending, thus reducing the money supply?

  1. When the bond is payed off it does lead to reduction in money supply unless the money are lent again. However, money supply is reduced just to the original point. If Fed injected 100 USD to the economy through OMOs and if through fractional reserve banking system that injection multiplied up to 1000 USD then repaying that debt only destroys the 1000 USD not any additional money (e.g. if M before injection was 1 billion USD after repayment it will again be just 1 billion USD).

  2. It does not reduce money supply further than it was before it was expanded. The interest rate is paid to the bank. In case of commercial banks they keep the money as a profit (after paying for all costs of course) so it will still be circulating in the economy. In case of US government paying interest to Fed, again money supply is not additionally destroyed because Fed is government institution and it sends all profits from interest back to the treasury (e.g. see WSJ article about profits they send back in 2020) so the money used to pay interest stays circulating in the economy.

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  • $\begingroup$ If a bank makes a loan at interest, and the loan is repaid with interest, then the net result would be a transfer of the interest payments from deposit liabilities to equity claims against the bank, all other factors held constant. If we count deposits in the money supply, but do not count equity claims in the money supply, then money supply is reduced by the interest payments. However in practice banks expand bank credit and they rollover and grow both deposit liabilities, paid in equity claims, and adjusted equity (adjusted for profit or loss). Interest is paid with money created by credit. $\endgroup$ May 18 at 20:12
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    $\begingroup$ @SystemTheory balance sheet has to balance if a bank has retained earning on equity side it has to have corresponding asset on asset side. That asset will be either their cash balance or their own deposits they use to pay their stuff and so on. So no the money supply is not reduced by bank getting interest payment $\endgroup$
    – 1muflon1
    May 18 at 20:50
  • $\begingroup$ This four page paper richmondfed.org/~/media/richmondfedorg/publications/research/…, for example, shows Bank assets on one side and liabities and equity on the other side of the balance sheet. There is no asset class that corresponds to liabilities or equity. There is a mix of assets, a mix of liabilities, and equity that can be classified as paid-in or adjusted for profit or loss from the past records on the income statements. So a bank creates deposits by expanding assets and cancels deposit liabilities to book fee or interest income. $\endgroup$ May 18 at 21:03
  • $\begingroup$ Just to clarify for anyone reading these comments, in case this is not clear, the "Cash" asset, shown in this reference richmondfed.org/~/media/richmondfedorg/publications/research/… on page 1 for a hypothetical bank balance sheet, refers to reserve balances and vault cash which are issued as liabilities of the central bank. The bank only holds reserve balances to clear interbank payment, unless the central bank forces some banks to hold excess reserves, and it only holds vault cash to service withdrawals, both because of the bank profit motive. $\endgroup$ May 18 at 21:16
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When Fed purchases securities from a bank (depository institution) the Fed pays with reserve balances, which are liabilities of the Fed and assets of the bank sector, so the transaction would be recorded as follows. On Fed balance sheet the Fed debits securities held as assets for an increase and Fed credits reserve balances due to bank sector for an increase. This expands the Fed balance sheet. On the Bank sector balance sheet there is a debit of reserve balance assets for an increase and a credit of securities held as assets for a decrease. This does not expand the Bank sector balance sheet. The initial result would be to increase base money, in the form of reserve balances, when Fed purchases securities from the Bank sector. In theory banks can sell securities to get reserve balances so securities and reserve balances are the liquidity cushion of the Bank sector. Banks would not sell all their securities to the Fed unless interest on excess reserves exceeds the interest earned on the Bank sector securities portfolio.

When Fed purchases securites from a nonbank unit the aggregate Bank sector clears payment between Fed and their nonbank customers. So Fed still debits securities on its balance sheet for an increase and credits reserve balances for an increase. Bank sector debits reserve balances for an increase and credits deposit liabilities due to the nonbank customer for an increase. The nonbanks that sell securities to Fed in open market operations (OMO) debit deposit assets for an increase and credit securities assets for a decrease.

Reserve balances are a component of base money or so-called M0 money supply. Some types of deposit liabilities are components of M1/M2 money supply. So when Fed does OMO operations with Bank sector as counter-party this would increase or decrease base money. When Fed does OMO with a nonbank this would either increase or decrease both base money and M1/M2 initially. However the aggregate Bank sector actively manages its mix of deposits, other liabilities, and equity so M1/M2 money "migrates" due to liabilities and equity management. Fed has no direct control over M1/M2 because the Bank sector interacts with nonbanks and the net result of Fed doing its thing and Banks doing their thing is the M1/M2 level at any point in time.

Banks tend to issue and expand credit (assets held) which tends to increase M1/M2 initially. But then bank sector liability management and nonbank portfolio allocation decisions mean no one is in control of the M1/M2 money supply levels.

Fed exists to kill rampant inflation and/or attempt to cause inflation to prevent a rapid debt deflation. This effort is more about the decisions being made in the credit system, the conditions in money and credit markets, than it is about the level of the money supply at any given time. During periods when financial markets operate in a predictable mode the money supply may correlate well with Fed policy. However the elastic money supply is a residual of all the transactions on the aggregate bank balance sheet which are driven by the Fed credit policy, the aggregate Bank sector credit policies, and the portfolio allocations of the nonbank sector.

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[...] there may be a slight reduction in the money supply if the bond is paid back with interest.

No because interest flows are not part of the bond that is paid back. They are a "co-object" of the debt, not an integral part of it. I.e. they have their own (potentially orthogonal) debt underlier somewhere in the world economy, be it "fully backed" (if, e.g. directly emitted by a central bank) or "fractionally backed" (if, e.g. created by a commercial bank).

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