Question

Walk me through a $100 "bailout" of a company and how it affects the 3 statements. First, confirm what type of "bailout" this is – Debt? Equity?

Income Statement:No changes.

Cash Flow Statement:Cash Flow from Financing goes up by $100 to reflect this new investment, so the Net Change in Cash is up by $100.

Balance Sheet:Cash is up by $100 so the Assets side is up by $100; on the other side, Shareholders’ Equity goes up by $100 to make it balance (Common Stock & APIC for a normal equity investment or Preferred Stock for preferred).

Answer 1

The Fed's open market purchase will increase Acme Bank's reserves by $10 million and decrease its bonds by the same amount. Acme can then use the added reserves to extend new loans. This action will alter Acme's balance sheet while initially leaving deposits and equity unchanged.

Step-by-step explanation:

Understanding the Balance Sheet Impact of a Fed Open Market Purchase

When the Federal Reserve (Fed) conducts an open market purchase by buying Treasury bonds from a bank, it alters the bank's balance sheet substantially.

For instance, if the Fed purchases $10 million in Treasury bonds from Acme Bank, Acme Bank's assets will shift. Specifically, Acme's reserves will increase by the same amount as the bonds' value because the Fed credits Acme's reserve account with this money.

Let's examine the original balance sheet of Acme Bank, which includes:

• Assets - reserves: 30, bonds: 50, and loans: 50
• Liabilities - deposits: 300 (or 100 in one version) and equity: 30

After the purchase:

• Assets: The reserves will go up by $10 million to 30 + 10,000 (since the Fed credits Acme's reserve account). Bonds will decrease by $10 million, assuming Acme sells all of its bond holdings to the Fed.
• Acme can then use these additional reserves to issue new loans, leading to an increase in the loans category.
• Liabilities: No immediate change will occur in the deposits or equity.

Hence, if Acme chooses to convert all the new reserve funds into loans, its new balance sheet would reflect reserves of $10,030, bonds at $0, and loans at $50 + 10,000.

The deposits and equity would remain initially unchanged. However, if Acme's new loans resulted in new deposits (as when the loan recipients deposit money in their accounts), the deposit liability would also increase, maintaining the principles of double-entry accounting.