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 do 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.