What happens when the Federal Reserve buys securities in the open market?

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vassy
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What happens when the Federal Reserve buys securities in the open market?

Post by vassy » 28 Jul 2017 15:17

Hi,
I have read that the Federal Reserve buys securities in open market to increase the money supply. But what happens to those securities? Does the Fed destroy it? Who eventually pays for those securities? e.g. The Fed buys a bond of $1 billion in open market. Now with the bond in hand one would expect to get the principal back with some interest when the bond matures. Who pays the principal with interest? I have searched a lot on the net regarding this but everywhere it is just mentioned that the Fed buys securities to increase money supply. No one mentioned what happens to that security after the Fed buys it. Disclaimer: I am not against the Fed or any thing like that. I am just curious to know.
Thanks!

Rysto
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by Rysto » 29 Jul 2017 12:15

The Fed holds the security in their inventory. Any interest or principle payments are returned to the US Treasury as US govt. revenue.

Note that when the Fed wishes to decrease the money supply, they sell securities out of their inventory, which removes money from the money supply.

vassy
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by vassy » 29 Jul 2017 14:57

Hi @Rysto,
Thanks for your reply. So now, for e.g., if the US Treasury sells $100 worth of securities in the open market. Say, the interest rate on those securities is 5% ($5 in this case). Now, these securities are sold to the dealers. Then to increase the money supply the Fed buys these securities from the dealers. The Fed may buy it at $102 (i don't know if its correct but that is how the dealers would make profit). Now, there are extra $2 in the economy which the Fed paid to the dealers. So, I agree the money supply has increased by $2. But since, the Fed has bought the securities from the dealers, the dealers need to pay back to the Fed $100 (the principal on the security) + $5 (the interest). So how is this increasing the money supply in the economy? Since, the dealers need to pay back to the Fed. I am a bit confused.

Rysto
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by Rysto » 30 Jul 2017 12:34

When the US Treasury issues securities, and uses the proceeds for government operations. So when the Treasury issues bonds, the money is not removed from the money supply. The US government is going to spend that money on something, which keeps it in the economy.

So if the Fed buys a security for $102, the whole $102 is added to the money supply, not just the $2 profit. Also, I'm confused why you think that the dealers would have to pay the Fed when the bond matures. The Treasury has to, but the Fed is just going to send the proceeds back to the Treasury, so there's no change in the money supply when this happens.

vassy
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by vassy » 30 Jul 2017 21:37

Hi Rysto,
Right. The treasury has to pay the Fed for the bonds. But where does the treasury get the money to pay the Fed? Is it by selling more securities? Or the Treasury does not really pay the Fed.
Thanks!

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LadyGeek
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by LadyGeek » 30 Jul 2017 22:41

Does this answer your question? Open Market Operations - OMO - watch the video.
Imagefiniki, the Canadian financial wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

vassy
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by vassy » 30 Jul 2017 23:29

Hi LadyGeek,

Thanks for the video. But I still have the question - when Fed has the bonds who pays the Fed when the bond matures? Assuming the Fed has not sold the bond in open market. Does the US Treasury pay the Fed? If so, where does US Treasury get the money to pay the price of the bond (plus some interest) to the Fed?

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LadyGeek
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by LadyGeek » 31 Jul 2017 21:36

Hi vassy,

My strong point is engineering, not economics. I don't have an understanding to answer your question with much confidence, but this article looks promising: How Is the Fed Monetizing the U.S. Debt?

Separately - if you haven't seen this video, it's worthwhile to watch this excellent tutorial for the underlying principles: How the Economic Machine Works [Animation] by Ray Dalio It's quite popular.

Just below the video is a detailed white paper.
Imagefiniki, the Canadian financial wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

Rysto
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Re: What happens when the Federal Reserve buys securities in the open market?

Post by Rysto » 01 Aug 2017 11:38

vassy wrote:
30 Jul 2017 23:29
Thanks for the video. But I still have the question - when Fed has the bonds who pays the Fed when the bond matures? Assuming the Fed has not sold the bond in open market. Does the US Treasury pay the Fed? If so, where does US Treasury get the money to pay the price of the bond (plus some interest) to the Fed?
The Treasury pays the Fed. They'll either get the money out of general revenues or by issuing a new bond.

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