Money Multiplier and Open Market Operations

Money Multiplier

• money multiplier (MM): the amount the money supply expands with each dollar increase in reserves
  • MM = deposits/reserves

2 Major Tools To Control the Money Supply

1. open market operations
2. paying interest on reserves held by banks at the Federal Reserve

Open Market Operations

• open market operations: the buying and selling of government bonds by the Federal Reserve
  • objectives:
  • influence the growth of the money supply
  • influence interest rates
• the Federal Reserve changes the money supply by buying or selling short-term government bonds (T-Bills for short)
  • if they buy government bonds, the money supply increases:
  • to pay for the T-Bills, the Federal Reserve electronically increases the reserves of the seller, usually a bank or large dealer (MB increases)
  • with more reserves, the bank makes additional loans, which are used to buy goods and pay wages
  • people will deposit some of these payments into other banks (checking deposits increases, M1 increases)
  • the new deposits increase the reserves of other banks, which will also make more loans (this is the beginning of the “money multiplier” process)
• summary:
  • the Federal Reserve can increase/decrease reserves at banks by buying/selling government bonds
  • the increase/decrease in reserve boosts/reduces the money supply through the money multiplier process
  • size of multiplier isn’t fixed but depends on how much of their assets the bank wants to hold as reserves
• when the Federal Reserve buys or sells bonds, it changes the monetary base and also influences the interest rates
• when the Federal Reserve buys bonds, it increases money supplies and lowers interest rates
  • the lower interest rates increase the quantity of loans demanded
• when the Federal Reserve sells bonds, the process works in reverse
• summary:
  • when the Federal Reserve buys or sells bonds, it changes the monetary base and influences interest rates at the same time
  • buying bonds stimulates the economy through higher money supplies and lower interest rates
  • when the Federal Reserve sells bonds, the process works in reverse (selling bonds dampens the economy through lower money supplies and higher interest rates)

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