I have been thinking about open market operations that the federal reserve performs to control the money supply and I have a question that I do not fully understand and it is bothering me. An answer to this question will be really appreciated.
Question: Let’s say that if the central bank is keeping the base money at 6% of the GDP then as the GDP expands then the central bank will also have to increase the money supply to keep it at 6% of the GDP. In that case the central bank will perform open market operations to pump extra money in the economy by buying treasury bills. Some of those treasury bills that central bank has on its balance sheet will mature and the central bank will have to replenish those by buying new treasury bills to keep the money supply constant at 6% GDP. So as the economy grows larger and larger, the central bank will be holding more and more treasury bills on its balance sheet and will have to conduct more and more open market operations to replenish the maturing treasury bills? Does that also imply that in an ideal world with no recession and constant GDP growth the central bank will always increase its balance sheet and the balance sheet of the central bank will not go down? Also, if the federal debt is paid off somehow then the central bank cannot use the treasury bill for open market operations so will they use some other type of instruments such as etfs to conduct open market operations? Thank you very much.
The money supply and the size of the central bank’s balance sheet are closely connected. Currently and historically, the sum of currency and bank reserves (a narrow definition of the money supply) account for almost all of the Fed’s liabilities. Turning to the asset side of the balance sheet, although the size of the Fed’s assets has grown in lockstep with its liabilities, the composition of assets has varied more over time. Over most of the post-WWII period, the Fed essentially held Treasury securities, but it has held other types of securities over the course of its history, including its large holding of agency and mortgage-backed securities in recent years, foreign currency, and gold. The Federal Reserve’s H.4.1 statistical release (http://www.federalreserve.gov/releases/h41/default.htm) provides detailed information about its balance sheet.
So, yes, the size of the central bank’s balance sheet will typically track the money supply. And, if the federal debt is ever completely paid off so that there is no supply of Treasury securities, the Fed will hold other assets instead.