Question

If the Federal Reserve conducts open market purchases,

a) How dill it affect money creation by banks? Why?

b) As a Result of this, when would the realistic money multiplier change? What kind of change?

Answer 1

a. FED uses OMO as a tool to control the money supply. Banks hold goevrmnet securities with the FED as a statuory procedure. SO, FED uses this linkage to change the money supply in the economy.

When FED purchases thru OMO, banks sell their G sec. Thus they Get money in return. Using this money banks can extend more loans than earlier. This pushes the interest rate downwards and boosts the growth prospect of the economy.

b. money multiplier is given as a ratio as 1 + CR / CR + RR. Even though OMO does not changes the reserve requirement say CRR, it will still incease the money multiplier though the lower interest rate which will bring more money into the system.

For a purchase of G sec it will be positive change.