Open market operations to control the money supply

[lllusi0n]

Chapter 11 – Page 25 – Open market operations

The notes describes that if the government wants to control the money supply then it can sell securities to the banks and private sector. As the banks and private sector buy these securities with cash the stock of high powered money is reduced.

What I am confused about is that on page 16 of the same chapter it defines MO (high powered money) as including deposits made with the central bank. If a private individual had bought a government security then have they not effectively deposited their money and as such M0 hasn’t actually reduced, i.e. is has just stayed the same.

The notes say that when cash is given to the Central back in return for these securities the money is then removed from the economy and M0 has reduced, even though the definition included money deposited in the Central bank.

This has been confusing me for a while and I must be reading this totally wrong. Please can any one help?

Hopefully this follows onto my next question

September 2006 – Question 20

I am also confused by the ActEd solution. It says that for option A, in order for the government to spend money e.g. on schools, it must have got the money from somewhere. To do this they have issued government bonds to fund this expenditure. This makes sense.

Where as for option B the government has increased the money supply by buying securities from the public and this increases the money supply. How in this case does the government magically have money to buy these securities and as such increase the money supply whereas in option A they need to fund there expenditure by selling securities. In my eyes they are the same, where has the government got this money from in order to buy the securites?

Why have they not needed to fund this before buying the securities from the public?

 

[Charlie]

I think the answer to your first question is that M0 includes deposits at the Central Bank (ie money that banks or the private sector deposit at the Central Bank). But if the Central Bank sells securities, then banks/the private sector are basically giving money to the Central Bank in return for the securities (rather than depositing their own money there, which they would be able to withdraw at a later date).

So in my mind, the Central Bank has an underground vault somewhere where it keeps a load of its own cash that is NOT deposits and so NOT part of M0. By buying and selling securities, it will be changing the amount of cash in this underground vault, and so changing the amount of money in public circulation and hence M0. (Of course, the underground vault is just what I visualise - I'm sure there's something more sophisticated in practice!)

For your second question, first of all, I think you need to make sure you know the difference between issuing (selling) and buying securities:

- Issuing (selling) bonds - which is what option A is talking about - means that the public buys the bonds and gives the government money for them. The government would issue bonds for two reasons. (1) It might issue bonds in order to raise money, so that it can spend it (this is what's happening in option A). Because it is taking money from the public (for the bonds), but then spends the money (ie putting it back into circulation), the money supply is unchanged. (2) It might issue bonds in order to reduce the money supply, in which case the public buy the bonds, and the government receives the money and then takes it out of circulation, hence reducing the money supply. (Maybe it puts the money in the Central Bank's underground vault!)

- Buying securities - which is what option B is talking about - means that the government buys existing bonds back from the public. If the government had money already (eg from tax revenues), then it could use that to buy the bonds back and the money supply would be unchanged. (But I can't really see the point of this and am not sure it would ever happen.) I think it's more likely that it would use "new" money to buy the bonds, hence increasing the money supply.

You're then asking how the government magically has money to buy these securities (in option B). Well I think the point is that it doesn't! In order to buy the securities, it'll have to print money. This is what the government is doing at the moment as far as I know...I think it's what is meant by "quantitative easing".

 

[Graham Aylott]

Another excellent answer Charlie.

In Option A of S2006 Q20, the question is (implicitly) assuming that the government funds its extra spending by additional tax revenue, as this is what happens under normal circumstances. (This is what is meant by fully funding - see page 27 of Chapter 11.) So, the government removes money from circulation via taxation, then spends it itself - meaning that the overall amount of money in circulation is unchanged.

However, at the moment it is about to/has just started "quantitative easing", i.e. which is effectively printing money, in order to try and increase the amount of money in banks, in the hope that this will enable them to start lending again. In effect, the Bank of England is about to press a button and create billions of pounds for itself. It will then go and spend this money buying assets (government and corporate bonds) from the banks, which then have more cash available to enable them to lend more/increase credit to the rest of us - in the hope that we will be able to go out and spend more, thereby avoiding a long recession.

However, this policy of printing money is exceptional, as it is potentially inflationary, but it may be justified at the moment by the exceptional nature of the current credit crunch.

 

[Cardano]

However, at the moment it is about to/has just started "quantitative easing", i.e. which is effectively printing money, in order to try and increase the amount of money in banks, in the hope that this will enable them to start lending again. In effect, the Bank of England is about to press a button and create billions of pounds for itself. It will then go and spend this money buying assets (government and corporate bonds) from the banks, which then have more cash available to enable them to lend more/increase credit to the rest of us - in the hope that we will be able to go out and spend more, thereby avoiding a long recession.

However, this policy of printing money is exceptional, as it is potentially inflationary, but it may be justified at the moment by the exceptional nature of the current credit crunch.

The problem here is not that the banks can't lend, its that they can't find any willing or qualified borrowers. This process was known as "debt revulsion" in the 19th century. When individuals and corporations get so indebted that they are "revolted" by taking on any more debt and the banks have made so many bad loans they are "revolted" by making any more loans, except when they are virtually risk free.

Far from shortening the recession, quantitative easing is likely to extend the recession as it will slow down the necessary debt liquidation (debt repayment and default). Bailing out insolvent financial institutions also prolongs the agony, because allowing a default liquidates the debt immediately whereas taking the banking sector liabilities onto the governments books means the government will have to liquidate its debt at a later stage, probably by inflationary default, when they get really serious about printing money and when individuals and corporations are again in a position to borrow

 

[lllusi0n]

Thanks for the replys, I think I understand now.