THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 551

CHAPTER 20 The International Financial System 519 First, it reduces the Bank s holding of international reserves by $1 billion Second, because the Bank s purchase of currency removes it from the hands of the public, currency in circulation falls by $1 billion We can see this in the following T-account for the Bank of Canada: Bank of Canada Assets Liabilities Foreign assets (international reserves) *$1 billion Currency in circulation *$1 billion Because the monetary base is made up of currency in circulation plus reserves, this decline in currency implies that the monetary base has fallen by $1 billion If instead of paying for the foreign assets sold by the Bank of Canada with currency the persons buying the foreign assets pay for them by cheques written on accounts at domestic banks, then the Bank deducts the $1 billion from the deposit accounts these banks have with the Bank of Canada The result is the deposits with the Bank of Canada (reserves) decline by $1 billion, as shown in the following T-account: Bank of Canada Assets Foreign assets (international reserves) Liabilities *$1 billion Deposits with the Bank of Canada (reserves) *$1 billion In this case, the outcome of the Bank of Canada sale of foreign assets and the purchase of dollar deposits is a $1 billion decline in reserves and, as before, a $1 billion decline in the monetary base because reserves are also a component of the monetary base We now see that the outcome for the monetary base is exactly the same when a central bank sells foreign assets to purchase domestic bank deposits or domestic currency This is why when we say that a central bank has purchased its domestic currency, we not have to distinguish whether it actually purchased currency or bank deposits denominated in the domestic currency We have thus reached an important conclusion: A central bank s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base We could have reached the same conclusion by a more direct route A central bank sale of a foreign asset is no different from an open market sale of a government bond We learned in our exploration of the money supply process that an open market sale leads to an equal decline in the monetary base; therefore, a sale of foreign assets also leads to an equal decline in the monetary base By similar reasoning, a central bank purchase of foreign assets paid for by selling domestic currency, like an open market purchase, leads to an equal rise in the monetary base Thus we reach the following conclusion: A central bank s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base