Kenneth R. Szulczyk
This transaction removed $10,000 of U.S. currency out of the international market because
the Fed holds the U.S. dollars. Consequently, the monetary base decreases by $10,000 while the
money supply contracts. Unfortunately, the Fed’s international reserves decline by $10,000. The
Fed does not buy U.S. currency. Instead, the Fed could accept a check for the foreign-currency
sales. When the Fed cashes a check, the Fed decreases the bank reserves as it removes money
from the banking system. We record the transaction below:
The Federal Reserve
Assets Liabilities
- $10,000 Foreign currencies – $10,000 Bank reserves
In this case, the monetary base still decreases by $10,000 while the money supply contracts.
It makes no difference whether the Federal Reserve accepts a check or cash denominated in U.S.
dollars. Both transactions impact the monetary base the same. If the Federal Reserve believes
the U.S. dollar is too strong, then the Fed can weaken or depreciate the dollar by selling U.S.
currency and buying foreign currencies. For example, the Fed buys $30,000 of foreign currency.
We record this transaction in the T-account below.
The Federal Reserve
Assets Liabilities
+$30,000 Foreign currencies +$30,000 Currency in circulation
The Federal Reserve’s assets increase by $30,000, increasing the monetary base by $30,000
and expanding the money supply. World’s economy has $30,000 more U.S. dollars in
circulation. If the Fed let these foreign exchange transactions change the monetary base, then we
call this unsterilized foreign-exchange intervention.
The Federal Reserve can prevent changes to the monetary base, when it influences the U.S.
dollar exchange rates, called sterilized foreign-exchange intervention. For example, the Fed
believes the dollar is too strong and wants to weaken it. The Fed buys $30,000 in foreign
currencies and sells $30,000 in U.S. currency, boosting the monetary base. However, the Fed
performs an open-market operation by selling $30,000 in T-bills for cash. These two
transactions cancel changes to the monetary base. Consequently, the change in the Fed’s assets
and liabilities are zero, and we record the transaction in the T-account below.
The Federal Reserve
Assets Liabilities
+$30,000 Foreign currencies
- $30,000 T-bills
+$30,000 Currency in circulation- $30,000 Currency in circulation