Question

When the Federal Reserve purchases bonds from Bank XYZ, where does it get the money to do so?

A. It prints new money
B. It borrows from the U.S. Treasury
C. It collects taxes
D. It uses its existing reserves

Answer 1

The Federal Reserve creates money to purchase bonds from banks through a process that credits the bank's account with the Federal Reserve, effectively increasing the money supply in the economy.

Step-by-step explanation:

When the Federal Reserve purchases bonds from a bank, like Bank XYZ, the money used to buy those bonds is not derived from an existing pile of cash, borrowing, or taxation. Instead, the Federal Reserve has the authority to create money. This process can sound a little mysterious, but essentially, the Federal Reserve simply credits the bank's account with the Federal Reserve for the amount of the bonds. This is akin to creating money 'out of thin air,' or with the modern equivalent of a few keystrokes on a computer to adjust the bank's balance.

When the Federal Reserve conducts this type of operation, which is known as an open market operation, it effectively increases the money supply in the economy. This can influence interest rates and overall economic activity. By buying bonds, the Federal Reserve is injecting liquidity into the banking system, making it easier for banks to lend and, therefore, stimulating economic growth.