Question

Suppose the Federal Reserve (Fed) decides to sell $100 million in Treasury bills on the open market. Further suppose that the Fed’s order is matched with a buy order from a member of the non-bank public. Assume the non-bank public deposits half of the proceeds from the sale in its account at Bank of America and takes the other half as cash.

1. Using T-accounts, show what happens to the balance sheets of the non-bank public, Bank of America, and the Fed. Then, explicitly state rather the monetary base increased or decreased and by how much.
2. Next, show graphically the impact of this change in the monetary base on money supply and the federal funds rate.

Answer 1

Balance sheet of Non banking Public

Assets Liabilities

   $50 Million in Cash

Bank of America

Assets        Liabilities

$50 Million in Securities

Federal Reserve

Assets        Liabilities

-$100 million in Securities

The monetary base decreases by $100 million

A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD₀) to shift left to AD₁, so that the new equilibrium (E₁) occurs at the potential GDP level of 700.