Question

Central Bank Balance Sheet

Assets Liabilities

Foreign assets $1,000 Deposits held by private banks $500

Domestic assets $1,500 Currency in circulation $2,000

Please write the new balance sheet if

1. The bank sells $100 worth of foreign bonds for domestic currency.  ​​​​​​​

2. The bank carries out a sterilized transaction by selling $100 of foreign assets ​​​​​​​

3. What should the bank do if its intent were to acquire more foreign assets but keep the money supply constant? How would the balance sheet change?

Answer 1

Given:

Central Bank Balance sheet

Assets	Liabilities
Foreign Assets            $1000	Deposits held by private banks        $500
Domestic Assets       $1500	Currency in circulation                     $2,000
$2500	$2500

The Central Bank’s assets and liabilities equal $2500.

1. The bank sells $100 worth of foreign bonds for domestic currency.  

Assets	Liabilities
Foreign Assets            $900	Deposits held by private banks        $500
Domestic Assets       $1500	Currency in circulation                     $1900

When the bank sells $100 worth of foreign bonds in the foreign exchange market, the foreign assets reduce from $1000 to $900. Since, the payment is received in the form of domestic currency; this payment is out of circulation. Currency in circulation reduces by $100.

2. The bank carries out a sterilized transaction by selling $100 of foreign assets

Assets	Liabilities
Foreign Assets            $900	Deposits held by private banks        $500
Domestic Assets       $1600	Currency in circulation                     $2000

A sterilized transaction is a policy when the Central Bank carries out an equal foreign and domestic transaction in an opposite manner to nullify the impact of their foreign exchange operations on the domestic money supply.

When the Central Bank sells $100 worth of foreign bonds in the foreign exchange market, the foreign assets reduce from $1000 to $900. To nullify the effect of the $100 decrease in foreign assets, the Central Bank can purchase $100 worth domestic assets. The liabilities side of the balance sheet does not change. The sterilized foreign exchange sale therefore has no effect on the money supply.

3. If the Central Bank wants to purchase more foreign assets by keeping money supply constant, it has to conduct a sterilized foreign exchange purchase.

For example, the Central Bank purchases foreign assets worth $100. It has to sell domestic assets worth $100 to keep the money supply constant. This is an example of a sterilized foreign exchange purchase.

Assets	Liabilities
Foreign Assets            $1100	Deposits held by private banks        $500
Domestic Assets       $1400	Currency in circulation                     $2000