Question

Describe how the Fed controls the money supply when it buys and sells federal government bonds. Which of these tends to expand the economy and which tends to contract it, buying or selling?  Why is this open market operations tool of the Fed more effective than changing the reserve requirements or simply adjusting the discount rate?

Answer 1

Answer - When the fed buys the government bonds from the general public it gives them money in return for the bonds . Hence there is increase in the supply of money in the economy. This tends to expand the credit activities in the economy.

On the other hand when the fed sells the government bonds , the public has to pay the money in order to purchase the bonds. Hence when the money is paid to fed , the money in circulation in the economy decreases and also the money supply decreases.

This tends to contract the credit activities in the economy as there is less money in circulation.

This is a more effective tool in comparison to the other tools because the money can be received or can be paid instantly. It is an efficient method of money supply control. It is also free because it functions in the open market hence less chances of inefficiency whereas the generation of reserves or the discount rate mechanism may take some time in showing its results.