If a central bank conducts an open market purchase in an economy with limited reserves, what would be the effect?
A. The effect on the money supply is greater than the effect on the monetary base
B. The effect on the money supply is lesser than the effect on the monetary base
C. The money multiplier impacts the monetary base
D. The money multiplier has no impact on the monetary base
E. Both A and C
Answer (2)
In an economy with limited reserves, an open market purchase increases the monetary base more than it increases the money supply. This is due to the money multiplier effect, which is negatively impacted by the limited capacity for banks to lend. Therefore, the correct answer is B.
;
When a central bank conducts an open market purchase, it buys government securities from the market. This action has several impacts on the economy, particularly on the money supply and the monetary base, especially in an economy with limited reserves.
Effect on the Monetary Base:
An open market purchase increases the monetary base because the central bank injects money into the banking system by purchasing securities. Banks receive reserves in return, which increases the amount of reserves they hold.
Effect on the Money Supply:
The increase in the monetary base generally leads to a multiplied effect on the overall money supply due to the money multiplier process. The money multiplier effect occurs because banks have more reserves and can issue more loans, which increases the money supply.
Explanation of the Money Multiplier:
The money multiplier reflects how much the money supply can increase from an additional dollar of reserves. The formula is typically stated as: Money Multiplier = Reserve Requirement Ratio 1
Choosing the Correct Multiple Choice Option:
From the options provided, "(A) The effect on the money supply is greater than the effect on the monetary base" is correct. This is because the additional reserves allow banks to lend more, thus expanding the money supply by a multiple of the increase in reserves.
Conclusion:
In summary, option (A) states that the effect on the money supply is greater than the effect on the monetary base due to the money multiplier effect, which is the most applicable result when a central bank conducts an open market purchase in an economy with limited reserves.
