Question

Explain how an open market purchase increases the money supply.

Short answer

An open market purchase increases the money supply as the central bank buys government bonds from banks, thus adding new reserves to banks. These new reserves enable banks to loan out more money, which increases the amount of money in circulation in the economy. Therefore, an open market purchase expands the money supply.

Step-by-step solution

Understanding Open Market Purchase

The first step is to understand what an open market purchase is. An open market purchase refers to the initiative taken by a central bank to buy government bonds from the market. The central bank performs this action when it aims to increase the money supply in the economy.

Effect on Bank Reserves

When a central bank makes an open market purchase, it buys bonds from banks and pays them with new money (reserves). This increases the amount of reserves banks have, which enables them to loan out more money.

Effect on Money Supply

As banks have more reserves, they are able to create more loans. This increases the amount of money in circulation and therefore, the money supply in the economy increases. Hence, an open market purchase by a central bank leads to an increase in the money supply in the economy.