Question

1) How does the central bank control the money supply through open market operations? Explain.

For this question, you need to say what exactly open market operations are and how they affect the monetary base through affecting reserves. You may want to provide one example for this question (eg. an open market purchase or sale). Ideally, to get full marks you would also briefly mention how the monetary base affects the money supply through the money multiplier. You don’t need to derive the money multiplier

Answer 1

The money circulating in the economy affects the economy both at micro and macro level that is at the unit as well as the aggregate level . so it is essential for the central bank to regulate the money supply which would help the direction the economy would be going.

Central Bank has many instruments which determine the money supply in an economy . one such instrument is open market operations. The government has formed an open Market Committee which determine the sale and purchase of open market operations as an instrument for controlling money supply. Open market operations are basically buying and selling of government securities from and to the public depending upon the need of increasing or decreasing the money supply.

This could be shown with an example. Suppose the central bank wants to increase the money supply in the economy so that the aggregate demand increases when the consumption investment and other spending would increase . The government would buy the government securities through open market operations which would inject more of the money in the economy since the government would be paying money when buying the securities. This would increase the money supply in the economy as there would be more monetary base in the economy that is when people would have more money they would consume more, save more and deposit in banks. The banks would lend this money through fractional reserve requirements by keeping a certain sum of money as reserves with them and lending the rest of the deposits . This would increase the money supply and hence economic activities would increase.

This method of open market operations is very flexible and easy to use for the government as an instrument to control the money supply