Answer to Question #217533 in Macroeconomics for Abhi

Question

If in an economy, people hold 70 percent of their money in the form of demand deposits and banks hold 10 percent of demand deposits as reserves, how will an open market purchase of bonds worth Rs 200 crores affect the overall money supply in the economy?

Answer 1

Open market operation regulates money supply through the purchase and sale of securities by the central bank of a country. If the central bank purchases bonds worth Rs 200 crores, it injects into the economy currency if the same worth as the bond. The public will in turn hold (200*0.7) RS 140 crores as demand deposits and hold the reset ( RS 60 crores) as cash in hand. The bank will in turn hold (0.1*140=14) RS crores as reserves and lends out the remaining, that is (140-14=126) RS crores. Assuming that the reserve ratio is 20% then 630 crores (126/0.2) will be given out as loans to the public due to the multiplier effect increasing the money supply in the economy. In general, the purchase of bonds from the public will increase the money supply in the economy to a greater multiplier.