1. The Federal Reserve purchases $1,000,000 of foreign assets for $1,000,000. Sh
ID: 2748960 • Letter: 1
Question
1. The Federal Reserve purchases $1,000,000 of foreign assets for $1,000,000. Show the effect of this open market operation using T-accounts.
2. Again, the Federal Reserve purchases $1,000,000 of foreign assets. However, to raise the funds, the trading desk sells $1,000,000 in T-bills. Show the effect of this open market operation using T-accounts.
5. If the balance in the current account increases by $2 billion while the capital account is off $3.5 billion, what is the impact on governmental international reserves?
Explanation / Answer
1. The Federal Reserve engages in open market operations (OMO) in order to regulate the supply of base money. The Federal Reserve when purchases $ 1,000,000 of foreign assets for $ 1,000,000 it will have to sell dollars in order to purchase assets denominated in foreign currency. This activity will increase it's international reserves and it can be explained with the help of T-accounts as follows:
Federal Reserve System
Assets
Liabilities
Foreign Assets (international reserves)
+ $1 million
Currency in circulation
+ $1 million
2. The Federal Reserve is now purchasing $ 1,000,000 of foreign assets by selling $ 1,000,000 of T-bills so this will not affect the liabilities of central bank. As they are converting one asset to another it can be explained with the help of T-accounts as follows.
Federal Reserve System
Assets
Liabilities
Foreign Assets (international reserves)
+ $1 million
Currency in circulation
0
5. The governmental international reserves are measured by the (Total of all receipts/inflows of current account + receipts of capital account - payments/outflows of current account - payment/outflows of capital account). Here the Current account is increasing by $ 2 billion and the capital account is decreasing by $3.5 billion. The net effect or impact of this transaction on the governmental international reserves is as follows:
Governmental International Reserves = ( + $ 2 billion - $ 3.5 billion) = - $ 1.5 billion
The governmental international reserves will decrease by $ 1.5 billion.
Federal Reserve System
Assets
Liabilities
Foreign Assets (international reserves)
+ $1 million
Currency in circulation
+ $1 million
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