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Chapter 13: Problem 3

Explain how an open market purchase increases the money supply.

Short Answer

Expert verified
An open market purchase increases the money supply as the central bank buys government bonds from banks, thus adding new reserves to banks. These new reserves enable banks to loan out more money, which increases the amount of money in circulation in the economy. Therefore, an open market purchase expands the money supply.

Step by step solution

01

Understanding Open Market Purchase

The first step is to understand what an open market purchase is. An open market purchase refers to the initiative taken by a central bank to buy government bonds from the market. The central bank performs this action when it aims to increase the money supply in the economy.
02

Effect on Bank Reserves

When a central bank makes an open market purchase, it buys bonds from banks and pays them with new money (reserves). This increases the amount of reserves banks have, which enables them to loan out more money.
03

Effect on Money Supply

As banks have more reserves, they are able to create more loans. This increases the amount of money in circulation and therefore, the money supply in the economy increases. Hence, an open market purchase by a central bank leads to an increase in the money supply in the economy.

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Most popular questions from this chapter

Suppose you read in the newspaper that all last week the Fed conducted open market purchases and that on Tuesday of last week it lowered the discount rate. What would you say the Fed is trying to do?

Explain how an open market sale decreases the money supply.

Suppose the Fed raises the required reserve ratio, a move that is normally thought to reduce the money supply. However, banks find themselves with a reserve deficiency after the required reserve ratio is increased and are likely to react by requesting a loan from the Fed. Does this action prevent the money supply from contracting as predicted? Explain your answer.

The Fed has announced a new, lower target for the federal funds rate; in other words, the Fed wants to lower the federal funds rate from its present level. What does setting a lower target for the federal funds rate have to do with open market operations?

Explain how a decrease in the required reserve ratio increases the money supply.
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