Question

Suppose the Fed conducts an open market purchase by buying $10 million in Treasury bonds from Acme Bank. Sketch out the balance sheet changes that will occur as Acme converts the bond sale proceeds to new loans. The initial Acme bank balance sheet contains the following information: Assets – reserves 30, bonds 50, and loans 50; Liabilities – deposits 100 and equity 30.

a. Reserves increase by $10 million, Loans increase by $10 million

b. Reserves increase by $10 million, Bonds decrease by $10 million

c. Reserves increase by $10 million, Deposits increase by $10 million

d. Reserves decrease by $10 million, Bonds decrease by $10 million

Answer 1

The correct answer is b. Reserves increase by $10 million, Bonds decrease by $10 million. When the Fed conducts an open market purchase, it buys Treasury bonds from a bank, which increases the bank's reserves. In this case, Acme Bank's reserves will increase by $10 million due to the open market purchase by the Fed. However, in order to convert the bond sale proceeds to new loans, Acme Bank will have to reduce its bond holdings by $10 million, resulting in a decrease in bonds.

Step-by-step explanation:

The correct answer is b. Reserves increase by $10 million, Bonds decrease by $10 million.

When the Fed conducts an open market purchase, it buys Treasury bonds from a bank, which increases the bank's reserves. In this case, Acme Bank's reserves will increase by $10 million due to the open market purchase by the Fed. However, in order to convert the bond sale proceeds to new loans, Acme Bank will have to reduce its bond holdings by $10 million, resulting in a decrease in bonds.