Question

4. Use the balance sheets to analyze the effects of open market operations.
(a) Suppose a central bank bought a $10,000 bond from a commercial bank, and to finish this transaction, the central bank put a credit of $10,000 into the commercial bank’s account with the central bank in exchange for bonds. What changes happen to the central bank’s balance sheet? What changes happen to the commercial bank’s balance sheet?
(b) Suppose a central bank bought a $10,000 bond from the public (any nonbank), and that nonbank seller of bonds keeps the proceeds as cash. What happens to the central bank’s balance sheet? What happens to the nonbank’s balance sheet?
(c) Explain the difference between these two situations in terms of the overall supply of money.

Answer 1

Open market operations refers to a central bank buying or selling short-term Treasurys and other securities in the open market in order to influence the money supply, thus influencing short term interest rates.

a) Central bank buying securities adds money to the system, making loans easier to obtain and interest rates decline.

Thus when central bank bought $10000 bond from commercial bank and put a credit of $10000 adds the liability part of central bank balance sheet and giving a potential asset in the books of commercial bank.

b) When a central bank buys a $10000 bond from any non bank where seller keeps the proceeds in cash will increase cash in hand asset in sellers books of account and will be added in the long term liability part of the buyer's(central bank) statement of financial position.

c) The main differnece is that in case a) where central bank buys a $10000 bond from a commercial bank and credits it in their books it shows that central bank bought the bonds buts is due in payment and hence money is not flowing into the economy. Hence money supply not increased.

whereas in case b) where the seller keeps the money in cash is differnent as the buyer paid the amount hence money flowing into the economy from central bank. Hence increasing the money supply in the economy but since tthey are cash in hand it is staying idle and money supply is not increased.