Question

1a. Using t-accounts for the Fed and a commercial bank show the accounting entries for a $25 million open market purchase. Explain what happens to the monetary base.  

  b. Using t-accounts for the Fed and a commercial bank show the accounting entries for the repayment of a $25 million discount rate loan by a commercial bank. Explain what happens to the monetary base.

c. Using t-accounts for the Fed, a commercial bank and a bank customer, show the accounting entries for a $1,000 cash deposit into a commercial bank by a bank customer. Explain what happens to the monetary base.

Answer 1

1.a) If the Fed buys bonds in the open market, it increases the money supply in the economy by procuring bonds in exchange for cash to the general public. In this case, commercial bank reserves maintained with Fed increases which in turn frees the commercial bank to lend out more increasing the money supply.

Acccounting entries in Fed books:

Bonds (Assets) - Debit (Increse in asset) $ 25 Million
To Commercial Bank Reserve (Increse in Liability) - Credit $ 25 Million
(Bonds purchased from commercial bank under open market operations)

Acccounting entries in Commercial bank books:

Reserve with Fed (Increse in Assets) - Debit $ 25 Million
To Bonds (Decrese in Assets) - Credit  $ 25 Million

(Bonds sold to Fed under open market operations)

(b) Reduction in money supply as balance wit Fed reduces due to book entries for loan repayment, forcing the commercial bank to decrese the lending for syncing with reserve kept with Fed:

Commercial bank books

Discount rate loan (Liability decrease) - Debit $25 million
To Balance with Fed (Assets decrease ) - Credit $25 million
(Loan repayment to Fed)

Fed books

Commercial Bank Reserve (Liability decrease) - Debit $25 million
To Discount rate loan (Assets decrease) - Credit $25 million
(Loan repayment by Commercial Bank)

(c) The cash deposit by customer increases money supply as the commercial bank

lends that amount basis the multiplier effect (keeping the reserves with Fed unchanged):

Commercial bank books

Cash - (Assets increase) - Debit $1000
customer Deposits(Liability increase) - Credit $1000
  
(Cash deposited by customer)

Customer books

Bank deposits ( Assets increase) - Debit $1000
To Cash (Assets decrease)   - Credit $1000

(Cash deposited in bank account)