Question

What are open market operations? Explain how an open market purchase works. Now show the impact of an open market purchase of $500 million worth of bonds by the Fed on the balance sheets of the banking system. Assume a reserve ratio of 10%.

Answer 1

An Open market operation is a monetary tool under which central bank buys or sells the government securities to change the money supply.

When the fed follows expansionary monetary policy, fed purchases government securities from the open market, which increases the money supply in the market. Due to more supply of money in the market, interest rate reduces. Now the cost of borrowing has reduced, firms will start borrowing more, which will lead to an increase in the production of goods and services. This will lead to an increase in the growth rate of the economy.

When the fed follows contractionary monetary policy, fed sells government securities in the open market, which decreases the money supply. Due to a low money supply in the market, interest rate starts increasing. Now, the cost of borrowing has increased, firms will borrow less, which will reduce lower investment. This will lead to a decrease in the growth rate of the economy.

To find the impact of an open market purchase of $500 million worth of bonds by the fed, we have to first find the money multiplier:

Money Multiplier = 1 / Reserve Ratio

Given, reserve ratio = 10%

Money muliplier = 1 / 10% = 1 / 0.1 = 10

So, to find the increase in money supply, when fed purchases $500 million worth of bonds we will multiply $500 by money multiplier which is 10. That means our money supply will increased by $5,000 million i.e. $500*10.

Hence, we can conlude that through a purchase $500 million worth of bonds by fed, money supply will increase by $5,000 million which will lead to a decrease in interest rate and increase in investment. This will increase the growth rate of the economy. Here, Fed is following expansionary monetary policy.