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What happens to Fed's balance sheet when its asset shrink in value? I noticed that Fed's balance sheet is special because I do not see any O.E. category (correct me if I am wrong). Suppsoe Fed's subprime MBS shrink in vlaue, its asset is decreased, but its liability doesn't (correct me if I am wrong), so it has an inbalance between A and L. If no O.E. is there, how can this be?

Also, Prof. Robert Shiller's "The Subprime Solution" says "if losses on collateral [during the crisis] mean that there are not enough funds to cover the defaulted loans, this will be reflected by the Fed paying less to the federal government, hence ultimately higher taxes for individuals." What does Prof. Shiller mean when he says not enough funds to cover the the defaulted loans and what does he mean by funds? What funds exactly? I mean, Fed has the ability to create reserve so how can there be not enough funds? One last question is why is the Fed paying the federal governemnt? I have never heard of Fed needing to pay the governemnt, shouldn't it be the governemnt pay the Fed due to the marturing of the T-bills and etc?

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  • $\begingroup$ Regarding your last question: central banks are indeed usually profitable as they earn so-called seigniorage. This used to be the earnings from actually printing money. Today, this is a bit more complicated, since printed money is no longer given to the government, but lent to banks. The banks however pay interest for the money they borrow which is today's seigniorage. The central bank pays these profits to the central government. $\endgroup$ – HRSE Nov 14 '15 at 2:09
  • $\begingroup$ @HRSE This is helpful. I think it answered my question about how the Fed pays money to the government while maintaining total reserve constant. But I do think knowing how Fed manages it when asset depreciates comparing to liability will help us understand what it means by Fed do not have enough funds to cover losses. $\endgroup$ – Kun Nov 14 '15 at 19:19
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When the Fed issues say 100k in liabilities (paper dollars) to buy 100k in assets (t-bills), then they will at the end of the year take their revenue from their assets, subtract their expenses and remit the profits to congress. This is an obscure process but it does exist. If you see a congressional budget, you'll see an item marked as miscellaneous revenue...this is a portion of if that. Now they do not remit as much as they should but that is another story.

If the Fed had to write off say 50k in bad debt, then that would count against their income for their year (and mean they earned 50k less). The 50k would actually be debited away from equity and not liabilities.

The Fed (that I know of), does not issue money directly to itself nor the treasury. It can create money to buy investments...and then spend the profits from investments on their own expenses. It can also sell equities for a profit (rarely done) to boost their equity.

A good question is what would happen if the Fed had to write off more in assets than they had in equity. I doubt they would shrink the monetary base to balance the books, but instead would fabricate an asset to keep the illusion going (like say a 'good will from the treasury').

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  • $\begingroup$ I think it is a great starting point in understanding the mechanics of Fed's accounting. Thanks! $\endgroup$ – Kun Nov 24 '15 at 14:25

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