module 27 The Federal Reserve: Monetary Policy 265
Section 5 The Financial Sector(a) An Open-Market Purchase of $100 MillionAssets Liabilities
Federal
ReserveMonetary +$100
base millionNo changeTreasury +$100
bills millionAssets Liabilities
Commercial
banksTreasury –$100
bills millionReserves +$100
millionfigure 27.2 Open-Market Operations by the Federal Reserve
In panel (a), the Federal Reserve increases the monetary base by
purchasing U.S. Treasury bills from private commercial banks in
an open-market operation. Here, a $100 million purchase of U.S.
Treasury bills by the Federal Reserve is paid for by a $100 million
increase in the monetary base. This will ultimately lead to an in-
crease in the money supply via the money multiplier as banks lend
out some of these new reserves. In panel (b), the Federal Reserve re-duces the monetary base by selling U.S. Treasury bills to private
commercial banks in an open-market operation. Here, a $100 million
sale of U.S. Treasury bills leads to a $100 million reduction in com-
mercial bank reserves, resulting in a $100 million decrease in the
monetary base. This will ultimately lead to a fall in the money supply
via the money multiplier as banks reduce their loans in response to a
fall in their reserves.(b) An Open-Market Sale of $100 MillionAssets Liabilities
Federal
ReserveMonetary –$100
base millionTreasury –$100
bills millionAssets Liabilities
Commercial
banksTreasury +$100
bills millionReserves –$100
millionNo changeWho Gets the Interest on the Fed’s Assets?
As we’ve just learned, the Fed owns a lot of
assets—Treasury bills—which it bought from
commercial banks in exchange for the mone-
tary base in the form of credits to banks’ re-
serve accounts. These assets pay interest. Yet
the Fed’s liabilities consist mainly of the mone-
tary base, liabilities on which the Fed doesn’t
pay interest. So the Fed is, in effect, an institu-
tion that has the privilege of borrowing funds at
a zero interest rate and lending them out at a
positive interest rate. That sounds like a pretty
profitable business. Who gets the profits?
You do—or rather, U.S. taxpayers do. The Fed
keeps some of the interest it receives to financeits operations but turns most of it over to the U.S.
Treasury. For example, in 2009 the Federal Re-
serve System received $52.1 billion in income—
largely in interest on its holdings of Treasury
bills, of which $46.1 billion was returned to
the Treasury.
We can now finish the story of the impact of
those forged $100 bills allegedly printed in North
Korea. When a fake $100 bill enters circulation,
it has the same economic effect as a real $100
bill printed by the U.S. government. That is, as
long as nobody catches the forgery, the fake bill
serves, for all practical purposes, as part of the
monetary base. Meanwhile, the Fed decides onthe size of the monetary base based on eco-
nomic considerations—in particular, the Fed
doesn’t let the monetary base get too large be-
cause that can cause inflation. So every fake
$100 bill that enters circulation basically means
that the Fed prints one less real $100 bill. When
the Fed prints a $100 bill legally, however, it gets
Treasury bills in return—and the interest on
those bills helps pay for the U.S. government’s
expenses. So a counterfeit $100 bill reduces the
amount of Treasury bills the Fed can acquire and
thereby reduces the interest payments going to
the Fed and the U.S. Treasury. So taxpayers bear
the real cost of counterfeiting.fyi
The change in bank reserves caused by an open -market operation doesn’t directly af-
fect the money supply. Instead, it starts the money multiplier in motion. After the $100
million increase in reserves shown in panel (a), commercial banks would lend out their
additional reserves, immediately increasing the money supply by $100 million. Some
of those loans would be deposited back into the banking system, increasing reserves