Open market purchases by the Fed:

Question

BlackTom AI · Accepted Answer

When the Fed conducts an open-market purchase, it buys government securities and pays by crediting the seller’s bank reserves, so reserves rise immediately and the money supply expands.

Relevant concepts:
- Open-market operations: Fed buys/sells government bonds to change bank reserves and the monetary base.
- Bank reserves and deposit creation: Increased reserves allow banks to lend more, creating new deposits through the money multiplier.
- Money multiplier: With required reserve ratio r, the potential maximum increase in the money supply ≈ (1/r) × change in reserves.

Step-by-step reasoning:
1. The Fed purchases government bonds (say $100 million) from a bank or nonbank seller.
2. The Fed pays by adding $100 million to commercial banks’ reserve accounts at the Fed (or the seller deposits the payment, which increases bank reserves). Thus reserves increase by $100 million immediately.
3. With higher reserves, banks can make new loans up to the excess reserves. If the required reserve ratio is r (for example 10% or 0.10), the money multiplier m = 1/r = 10.
4. The potential total increase in the money supply = change in reserves × money multiplier = $100 million × 10 = $1,000 million. The initial $100 million is part of the monetary base; subsequent lending/deposit rounds expand deposits up to the multiplier amount (subject to banks’ willingness to lend and public demand for deposits).

Why the correct answer is correct:
- Open-market purchases increase reserves (direct effect) and, through the lending/deposit process, increase the broader money supply (indirect effect).

Why other choices are incorrect:
- (b) says reserves increase but money supply decreases — inconsistent: higher reserves enable lending, not contraction.
- (c) describes open-market sales (Fed sells bonds), which reduce reserves and money supply — not purchases.
- (d) claims reserves decrease while money supply increases — contradictory to the mechanics of banking.

Conclusion: The correct choice is a. increase reserves and increase the money supply, which matches the provided answer.

Open market purchases by the Fed:Single choice

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