Question

Suppose the Fed decided to purchase $5,000,000 worth of foreign assets for $5,000,000.
Calculate the effect of the transaction using T-accounts.
What would be your answer if the Fed decided to do it through T-bills?

Answer 1

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Answer:

a)

. Represent the impact of a $5,000,000 purchase of foreign assets with currency by the Federal Reserve using the T-account as below:

Federal Reserve
Assets	Liabilities
Foreign assets $5,000,000	Currency in circulation $5,000,000

The Fed’s liabilities increase by $5,000,000 in currency because it uses that money to purchase foreign assets, which increases the ‘foreign assets’ category by an equivalent amount. The monetary base is defined as the sum of currency circulating in the public and commercial banks' reserves with the central bank.

Since the currency in circulation has increased. Thus, the monetary base will increase by $5,000,000.

b)

The impact of a $5,000,000 purchase of foreign assets by selling T-bills is shown on the T-account below:

Federal Reserve
Assets	Liabilities
Securities (T-bills) -$5,000,000 Foreign assets $5,000,000

The Fed is basically swapping T-bills with foreign assets. It did not use currency to make this purchase and the composition of assets changes, but the total does not.

Thus, the monetary base does not change.