What is the typical effect of an open market purchase by the central bank?

What is the typical effect of an open market purchase by the central bank?

• A. Increase money supply and lower short-term rates.
• B. Decrease money supply and raise rates.
• C. Have no impact on short-term rates.
• D. Only affect long-term rates.

Answer: (A)

Open market purchases inject reserves into the banking system. When the central bank buys government securities, it credits banks’ reserves, expanding the monetary base and the money supply. With more liquidity available, banks can lend at lower short-term rates, so these operations typically push down short-term interest rates. The action is a monetary stimulus, not a tightening, so it does not decrease the money supply or raise rates. It also directly affects short-term liquidity rather than only long-term rates, which is why the standard result is an increase in money supply and a decline in short-term rates.

Open market purchases inject reserves into the banking system. When the central bank buys government securities, it credits banks’ reserves, expanding the monetary base and the money supply. With more liquidity available, banks can lend at lower short-term rates, so these operations typically push down short-term interest rates. The action is a monetary stimulus, not a tightening, so it does not decrease the money supply or raise rates. It also directly affects short-term liquidity rather than only long-term rates, which is why the standard result is an increase in money supply and a decline in short-term rates.