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4. Open Market Operations

We come now to by far the most important method by which the Central Bank determines the total

amount of bank reserves, and therefore the total supply of money. In the United States, the Fed by this method

determines total bank reserves and thereby the total of bank demand deposits pyramiding by the money

multiplier on top of those reserves. This vitally important method is open market operations.

Open market, in this context, does not refer to a freely competitive as opposed to a monopolistic

market. It simply means that the Central Bank moves outside itself and into the market, where it buys or sells

assets. The purchase of any asset is an open market purchase; the sale of any asset is an open market sale.

To see how this process works, let us assume that the Federal Reserve Bank of New York, for some

unknown reason, decides to purchase an old desk of mine. Let us say that I agree to sell my desk to the Fed

for $100.

How does the Fed pay for the desk? It writes a check on itself for the $100, and hands me the check

in return for the desk, which it carts off to its own offices. Where does it get the money to pay the check? By

this time, the answer should be evident: [p. 155] it creates the money out of thin air. It creates the $100 by

writing out a check for that amount. The $100 is a new liability it creates upon itself out of nothing. This

new liability, of course, is solidly grounded on the Fed’s unlimited power to engage in legalized counterfeiting,

for if someone should demand cash for the $100 liability, the Fed would cheerfully print a new $100 bill and

give it to the person redeeming the claim.

The Fed, then, has paid for my desk by writing a check on itself looking somewhat as follows:


Pay to the Order of Murray N. Rothbard $100.00


Mr. Blank


Federal Reserve Bank of New York

There is only one thing I can do with this check. I cannot deposit or cash it at the Fed, because the

Fed takes only deposit accounts of banks, not individuals. The only thing I can do is deposit it at a commercial bank. Suppose I deposit it in my account at Citibank. In that case, I now have an increase of $100 in my

demand deposit account at Citibank; the bank, in turn, has a $100 check on the Fed. The bank greets the

check with enthusiasm, for it now can rush down to the Fed and deposit the check, thereby obtaining an

increase in its reserves at the Fed of $100.

Figure 10.7 shows what has happened as a result of the Fed’s purchase of my desk. The key

monetary part of the transaction was not the desk, which goes to grace the increased furniture asset column of

the Fed’s ledger, but that the Fed has written a check upon itself. I can use the check only by depositing it in a

bank, and as soon as I do so, my own money supply in the form of demand deposits goes up by $100. More

important, my [p. 156]

Figure 10.7 Open Market Purchase

bank now deposits the check on the Fed at that institution, and its total reserves also go up by $100. The

money supply has gone up by $100, but the key point is that reserves have gone up by the same amount, so

that the banking system will, over a few months, pyramid more loans and demand deposits on top of the new

reserves, depending on the required reserve ratio and hence the money multiplier.

Note that bank reserves have increased by the same amount (in this case, $100) as the Fed’s open

market purchase of the desk; open market purchases are a factor of increase of bank reserves, and in

practice by far the most important such factor.

An open market sale has precisely the reverse effect Suppose that the Fed decides to auction off

some old furniture and I buy [p. 157] one of its desks for $100. Suppose too, that I pay for the sale with a

check to the Fed on my bank, say, Citibank. In this case, as we see in Figure 10.8, my own money stock of

demand deposits is decreased by $100, in return for which I receive a desk. More important, Citibank has to

pay the Fed $100 as it presents the check; Citibank pays for it by seeing its reserve account at the Fed drawn

down by $100.

Figure 10.8 Open Market Sale

Total money supply has initially gone down by $100. But the important thing is that total bank reserves

have gone down by $100, which will force a contraction of that times the money multiplier of bank loans and

deposits, and hence of the total money supply.

Therefore, if open market purchases of assets by the Fed are a factor of increase of reserves by the

same amount, the other side of the coin is that open market sales of assets are a factor of decrease.

From the point of view of the money supply it doesn’t make any difference what asset the Fed buys;

the only thing that matters is the Fed’s writing of a check, or someone writing the Fed a check. And, indeed,

under the Monetary Control Act of 1980, the Fed now has unlimited power to buy any asset it wishes and up

to any amount—whether it be corporate stocks, bonds, or foreign currency. But until now virtually the only

asset the Fed has systematically bought and sold has been U.S. government securities. Every week, the

System Manager (a vice-president of the Federal Reserve Bank of New York) buys or sells U.S. government

securities from or to a handful of top private dealers in government securities. The System Manager acts under

the orders of the Fed’s Federal Open Market Committee, which meets every month to issue directives for the

month. The Fed’s System Manager mostly buys, but also sells, an enor mous amount, and every year the

accumulated purchases of U.S. Treasury bills and bonds drive up bank reserves by the same amount, and

thereby act to fix total reserves wherever the Fed wishes, and hence to determine the total money supply

issued by the banks. [p. 158]

One reason for selecting government bonds as the major asset is that it is by far the biggest and most

liquid capital market in the country. There is never any problem of illiquidity, or problem of making a purchase

or sale in the government securities market

How Fed open market purchases have been the driving force of monetary expansion may be quickly

seen by noting that the Fed’s assets of U.S. government securities, totalling $128 billion in January 1982, was

by far the bulk of its total assets. Moreover, this figure contrasts with $62 billion owned in 1970, and $27

billion owned in 1960. This is roughly a 17% annual increase in U.S. government securities owned by the Fed

over the past two decades. There is no need to worry about the ever-shifting definition of money, the

ever-greater numbers of Ms. All that need be done to stop inflation in its tracks forever is to pass a law

ordering the Fed never to buy any more assets, ever again. Repeatedly, governments have distracted attention from their own guilt for inflation, and scapegoated various groups and institutions on the market Repeatedly,

they have tried and failed to combat inflation by freezing wages and prices, equivalent to holding down the

mercury column of a thermometer by brute force in order to cure a fever. But all that need be done is one

freeze that governments have never agreed to: freezing the Central Bank. Better to abolish central banking

altogether, but if that cannot be accomplished, then, as a transitional step, the Central Bank should be frozen,

and prevented from making further loans or especially open market purchases. Period.

Let us see how a government bond purchase by the Fed on the open market increases reserves by the

same amount Suppose that the Fed’s System Manager buys $1,000,000 of government bonds from private

bond dealers. (Note that these are not newly issued bonds, but old bonds previously issued by the Treasury,

and purchased by individuals, corporations, or financial institutions. There is a flourishing market for old

government [p. 159] securities.} In Figure 10.9, we show the System Manager’s purchase of $1,000,000 in

government bonds from the securities dealer firm of Jones & Co. The Fed pays for the bonds by writing a

check for $1,000,000 upon itself. Its assets increase by $1,000,000, balanced by its liabilities of

newly-created deposit money consisting of a check upon itself. Jones & Co. has only one option: to deposit

the check in a commercial bank. If it deposits the check at Citibank, it now has an increase of its own money

supply of $1,000,000. Citibank then takes the check to the Fed, deposits it there, and in turn acquires a new

reserve of $1,000,000, upon which the banking system pyramids reserves in accordance with the money


Figure 10.9 Fed Purchase of Government Securities from Dealer

Thus, a Fed purchase of a $1,000,000 bond from a private bond dealer has resulted in an increase of

total bank reserves of $1,000,000, upon which the banks can pyramid loans and demand deposits.

If the Fed should buy bonds from commercial banks directly, the increase in total reserves will be the

same. Thus, suppose, as in Figure 10.10, the Fed buys a $1,000,000 government bond from Citibank. In that

case, the results for both are as follows: [p. 160]

Figure 10.10 Fed Purchase of Government Securities from Bank

Here when the Fed purchases a bond directly from a bank, there is no initial increase in demand

deposits, or in total bank assets or liabilities. But the key point is that Citibank’s reserves have, once again,

increased by the $1,000,000 of the Fed’s open market purchase, and the banking system can readily pyramid

a multiple amount of loans and deposits on top of the new reserves.

Thus, the factors of increase of total bank reserves determined by Federal Reserve [that is, Central

Bank) policy, are: open market purchases and loans to banks, of which the former are far more important. The

public, by increasing its demands for cash (and for gold under the gold standard) can reduce bank reserves by

the same amount [p. 161] [p. 162] [p. 163]