Question

Explain how the Fed uses open market operations to influence the money supply. Explain both an open market purchase and an open market sale.

Answer 1

The Feb uses open market operations to control the money supply. In open market operations, the Fed buys or sells Treasury securities to control the money supply.

When the Fed wants to increase the money supply, it buys securities from the banks. When the Fed buys Treasury securities from banks, the Fed credits the amount against the reserve account of the banks with the Fed. This increases the reserves of the banks with the Fed which they can lend to borrowers. Therefore, the money supply increases.

When the Fed wants to decrease the money supply, it sells securities to the banks. Banks buy the securities and their reserve account is debited for the funds. So, less amount of funds become available for lending. This reduces the money supply.