Macroeconomics
Numerical example: Suppose that the central bank buys $10,000 worth of bonds from commercial bankX.Thereservesof commercial bank X have nowincreasedby$10,000.Ifit’snotworthittokeepexcessreserveswiththe central bank (i.e., IOR is too low), commercial bank X will use that money to make loans. Since this amountisnotpartofdemanddepositliability(sinceit’srecordedasexcessreserves),commercialbankX canloanouttheentire$10,000,whichincreasescurrencyincirculation(partofMBandM1)by$10,000. Assuming that the multiplier is equal to 2, then the money supply will increase by: $10,000 × 2 = $20,000. ThisprovesthatwhentheFedconductsOMOs,theeffectonthemoneysupply ($20,000) isgreater than the effect on the monetary base ($10,000) becauseof the money multiplier. The opposite is true for all these steps assuming that the Fed sells bonds instead of buying them. However, the fnal result will be negative due to money destruction which is the opposite of money creation. In this case, money supply decreases.
Below is a summary of the effects of OMOs.
Table 4: Effects of Open Market Operations on Money Supply and Interest Rate OMO in a Limited Reserve Banking System Effect
Bank reserves ↑ → Ms ↑ by an amount equal to money multiplier × change in reserves → Nominal interest rate ↓ Bank reserves ↓ → Ms ↓ by an amount equal to money multiplier × change in reserves → Nominal interest rate ↑
The Fed buys securities
The Fed sells securities
Study Tip Alwayspayattentiontowhetheryouareaskedtocalculatethemaximumamountofloansthatcanbe created following a deposit ([deposit − reserves] × MM) or the maximum change in money supply followingacertainoperation(changeinMB×MM).RefertoSectionEofthischaptertounderstandthe difference between these two measures. Keep in mind that OMOsarecommonlyusedinbankingsystemswithlimitedreservestoinfluence interest rates through money supply, whereas they are only usedinbankingsystemswithample reserves (e.g., the U.S.) to maintain suffcient reserves as they do not have a notable effect on interest rates (this will be justifed in an upcomingsection). The Discount Rate, Federal Funds Rate, and Interest on Reserves As part of monetary policy,centralbanksuseandtargetdifferentratestoinfluencethemoneysupply and/or interest rates, depending on the banking system.
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