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Principles of Macroeconomics 3e

C | How Open Market Operations Affect Balance Sheets in a Limited Reserves Environment

Principles of Macroeconomics 3eC | How Open Market Operations Affect Balance Sheets in a Limited Reserves Environment

As we noted in our discussion of open market operations, in a limited reserves environment the FOMC can affect banks' balance sheets and the money supply. The following figures shows this process in detail.

Changes in Happy Bank's Balance Sheet

Figure C1

Figure C1 (a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million. When the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the bank’s reserves rise by $20 million, as Figure C1 (b) shows. However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves with which it started in Figure 15.5) (a), so the bank decides to loan out the extra $20 million in reserves and its loans rise by $20 million, as Figure C1 (c) shows.

Figure C2

Figure C2 (a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market. When Happy Bank purchases $30 million in bonds, Happy Bank sends $30 million of its reserves to the central bank, but now holds an additional $30 million in bonds, as Figure C2 (b) shows. However, Happy Bank wants to hold $40 million in reserves, as in Figure C2 (a), so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level, as Figure C2 (c) shows.

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