Question

Imagine a central bank that sells 100B of government bonds to its banking system in an open market operation. Immediately after the transaction, the balance sheet of the central bank shrinks by 100B, while the balance sheet of the banking system is unchanged.

Answer 1

Open Market Operations are a powerful monetary tool used by central banks to control the money supply thorugh buying and selling of bonds from and to the banking system of a country. When Central bank sells 100B of government bonds, it is a contractionary monetary policy as it takes away banking systems lending capacity. However, there is no change in balance sheet of the banking system as it only causes money to shift from loans to reserves. For example, let us say that the balance sheet of the banking system has $60 worth reserves, $200 worth of bonds and $300 worth of loans and the liabilities are equal to $400, theefore, the net worth of this banking system is $160. Let the value of 100B be equal to $40, then when Central banks sells 100B to other banks, bonds increase by a value of $240, and reserves fall to $20. Other banks want to keep reserves at $60 as it is the requirement, therefore, loan amount falls by $40 to keep reserves intact ($20 +40=60) and new loan amount is equal to $260. There is no change in the balance sheet ( assets = liabilities = 560) but only shifting of money from loan to reserves. Therefore, selling of bonds lead to lower money supply available.