AP Syllabus focus: ‘Open-market purchases increase reserves and the monetary base, while open-market sales decrease them; in limited-reserve systems, the money supply changes by more because of the multiplier.’
Open-market operations are the central bank’s routine way to adjust the banking system’s reserves.
This money-market diagram for bank reserves shows the demand for reserves and the (vertical) supply of reserves, with the federal funds rate (FFR) determined at their intersection. In a limited-reserves framework, an open-market purchase shifts the supply of reserves to the right (more reserves), tending to lower the FFR; an open-market sale shifts it left, tending to raise the FFR. Source
By buying or selling securities, the central bank changes the monetary base directly and can trigger larger money supply changes.
What Open-Market Operations Do
Core idea
An open-market operation (OMO) changes the quantity of reserves held by banks, which changes the monetary base (also called high-powered money). The central bank typically conducts OMOs by trading government securities with banks or other financial institutions.
Open-market operation: A central bank purchase or sale of securities in the open market that changes bank reserves and therefore the monetary base.
A key feature of OMOs is that they are an asset swap for the private sector: the central bank exchanges securities for central bank money (reserves), or vice versa.
The Monetary Base and Why OMOs Affect It
Monetary base components
The monetary base is the “raw material” the banking system uses to support deposits.
Monetary base: The sum of currency in circulation and bank reserves held at the central bank.
The central bank controls the monetary base because it is the monopoly issuer of bank reserves and currency.
= monetary base (dollars)
= currency in circulation held by the public (dollars)
= reserves held by banks (dollars)
In typical OMOs, the immediate effect is on R (reserves), so MB changes right away even if currency held by the public does not.
Open-Market Purchases: Increasing Reserves and the Monetary Base
Mechanics and direction of change
When the central bank conducts an open-market purchase, it buys securities and pays by creating new reserves.
Central bank buys securities from a bank or a dealer.
Payment is made as a credit to the seller’s bank’s reserve account at the central bank.
Bank reserves rise, so the monetary base rises.
This directly matches the syllabus requirement: open-market purchases increase reserves and the monetary base.
What “increase in reserves” means operationally
Reserves are the settlement asset of the banking system. When reserves increase:
Banks have more funds available to meet payments and regulatory needs.
Banks may have a greater capacity (and willingness) to expand lending, depending on the system and conditions.
Open-Market Sales: Decreasing Reserves and the Monetary Base
Mechanics and direction of change
When the central bank conducts an open-market sale, it sells securities and receives payment in reserves.
Central bank sells securities to a bank or dealer.
The buyer’s bank pays by transferring reserves to the central bank.
Bank reserves fall, so the monetary base falls.
This directly matches the syllabus requirement: open-market sales decrease reserves and the monetary base.
Why Money Supply Can Change by More Than the Monetary Base (Limited-Reserve Systems)
The multiplier logic (conceptual)
In a limited-reserve (scarce-reserve) system, banks’ lending and deposit creation are constrained by reserve availability and reserve requirements more tightly than in ample-reserve systems. An OMO changes reserves first, and then the banking system can expand or contract deposits by multiple rounds of lending and re-depositing.
This fractional-reserve banking diagram illustrates how an initial deposit can be re-lent and re-deposited repeatedly, producing a cumulative expansion in total deposits. The tapering shape highlights that each round is smaller because banks hold back required reserves each time, which is the intuition behind the multiplier process. Source
An open-market purchase raises reserves, supporting more deposit creation.
An open-market sale lowers reserves, forcing contraction in deposits and lending.
So, as the syllabus states, the money supply changes by more because of the multiplier in limited-reserve systems.
= change in the money supply (dollars)
= money multiplier (unitless)
= change in the monetary base (dollars)
The size of the multiplier effect depends on how much of new reserves banks keep versus convert into loans, and how much of resulting deposits the public holds as currency rather than deposits.
FAQ
OMOs settle through reserve accounts at the central bank.
Timing matters because settlement determines when reserves actually change, which can affect:
end-of-day reserve balances,
payment system liquidity,
short-term funding conditions.
Government securities are widely traded and considered low credit risk.
They also:
have deep, liquid markets,
allow precise sizing of operations,
minimise political concerns about allocating credit to specific private borrowers.
Yes, indirectly.
If banks or the public convert deposits into cash (withdrawals), reserves can be transformed into currency. This shifts the composition of $MB$ between $R$ and $C$ without necessarily changing total $MB$ one-for-one over short horizons.
Outright OMOs permanently exchange securities for reserves.
Repo-style operations (repurchase agreements) are temporary:
reserves rise initially,
then reverse when the repo matures, making them useful for short-term reserve management.
Even if reserves rise, money supply growth can be muted if:
banks choose to hold the added reserves,
borrowers are unwilling or unable to take loans,
risk constraints tighten, limiting credit creation,
the public increases currency holdings, reducing deposit expansion.
Practice Questions
Explain what happens to bank reserves and the monetary base when a central bank makes an open-market purchase. (2 marks)
Reserves increase. (1)
The monetary base increases (because and rises). (1)
A central bank conducts an open-market sale of government securities in a limited-reserve system. Explain how this can lead to a decrease in the money supply that is larger than the initial change in the monetary base. (6 marks)
An open-market sale reduces bank reserves. (1)
The monetary base falls because and falls. (1)
With fewer reserves, banks have reduced capacity to support deposits/loans (reserve constraint). (1)
Banks reduce lending and/or call in loans, leading to falling deposits. (1)
The contraction can occur in multiple rounds through the banking system (deposit shrinkage). (1)
Therefore the money supply can fall by a multiple of the initial due to the multiplier process. (1)
