Question

Describe how expansionary activities conducted by the Federal Reserve impact credit availability, the money supply, interest rates, and security prices. Suppose the Federal Reserve purchases $10 billion worth of foreign currency in exchange for deposit accounts at the Federal Reserve. Show the changes that result from this transaction on the Fed’s balance sheet.

Answer 1

The Federal Reserve influences the money supply in the economy through open market operations and monetary policy. Through the monetary policy, the Fed influences the interest rates, reserves requirements etc. in the market, thus influencing the commercial banks to lend more or less favorably. By this way, the Fed influences the inflation and growth of the economy. Through open market operations, the Fed directly purchases or sells securities in the market, thus affecting the money supply.

When the Fed conducts expansionary activities under expansionary monetary policy, it basically is focusing on encouraging the economic growth and/or tackle inflation by expanding the money supply, lowering interest rates, lowering the benchmark rates, lowering reserve requirements for the commercial banks etc. through these activities, the money supply with the commercial banks in the economy increases, the money required with them for lending increases and the overall credit available in the market increases as well. The interest rate go down by the principal of supply and demand as there is additional supply of money in the market. In some cases, the Fed lowers the interest rates (for repo, reverse repo, overnight borrowing) and benchmark rates. The inflation in general increases, though the increases it bit delayed and not observed immediately. The security prices increases as well. If the increase in security prices and inflation continues for too long, it is called as the economy heating up. Ideally, the Fed or the government would intervene and reverse the trend before this situation.

The balance sheet of the Fed would look as below before and after the purchase-

Partial balance sheet before the purchase -
Federal reserves
Assets	Amount (Bn)	Liabilities	Amount (Bn)
Deposits	20	Currency	10
Foreign Exchange Reserves	0	Reserves	10
Fed buys foreign currency worth $10bn
New partial balance sheet after the purchase-
Federal reserves
Assets	Amount (Bn)	Liabilities	Amount (Bn)
Deposits	10	Currency	10
Foreign Exchange Reserves	10	Reserves	10

Notice how 1 balance sheet (deposits) asset has changed to another balance sheet asset (foreign currency). The deposits here are the assets of Fed held. It converted them to currency and the purchased foreign currency in exchange of this currency.