Question

Explain how the Fed increases the money supply when it buys bonds in the open market.

Answer 1

The Fed buys bonds to increase the amount of reserves that banks have on hand.When the Fed buys bonds, the dollars that it pays to the public for the bonds increase the monetary base, and this in turn increases the money supply. The money multiplier is not affected, assuming no change in the reserve-deposit ratio or the currency-deposit ratio.When the Fed buys bonds, banks have more reserves and are able to lend more. As banks lend more, the money supply increases.