Question

What happens to the balance sheet of the Fed and what happens to the balance sheet of the bank that sells the security to the Fed? Please explain.

what is the link between the Federal Reserves purchase of a security from the banking system. and an increase in the supply of money as defined by M1. Let's say the security they buy is a U.S. Treasury Bond

Answer 1

Lets first see how the balance sheets of the Fed and a commercial bank look in general. Then we can see how they change when the bank sells security to the fed.

Fed Balance sheet-

Commercial Bank balance sheet-

When the Fed buys the bonds from a bank, its assets increase (because the bonds are financial assets). In return of the bonds, the Fed gives the bank cash. This increases the liabilities of the Fed by the same amount and hence make the balance sheet 'balanced'.

The commercial bank, on the other hand, had security as assets. As the bank sells those to the Fed, its asset decrease. But at the same time, it recieves money from the Fed and hence its reserves increase by the same amount. So the balance sheet remains 'balanced'.

Part 2-

As the Fed purchases the U.S. Treasury Bonds from the bank, it gives money in return. This money goes to the reserves of the bank. But since bank's deposits are same, its reserve requirements are same. So, it now has excess reserves. What will the bank do with excess reserves? It will loan them out, of course. These loans then increase the money supply in the economy.

-----

Please upvote if you like my answer. Thank you.