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When the Fed makes a purchase or a sale, the monetary base changes. (What the Fed primarily
buys and sells is U.S. government securities.) When the Fed makes a purchase, the monetary
base increases. When the Fed makes a sale, the monetary base decreases.
Example 1A: The Fed buys $250,000 of U.S. government securities in the open market. The
seller is Bank Y. The Fed pays Bank Y for the securities by increasing Bank Y’s deposit account
balance with the Fed by $250,000. Bank Y now has $250,000 in new reserves. Thus, there is a
$250,000 increase in monetary base.
Example 1B: The Fed sells $100,000 of its holdings in U.S. government securities. The buyer is
Bank Z. Bank Z pays for the securities by using some of its excess reserves. Bank Z now has
$100,000 less in reserves. Thus, there is a $100,000 decrease in monetary base.
The Actual Money Multiplier
When the monetary base changes, money creation or money destruction is triggered, and the
money supply changes by a multiplied amount. The actual money multiplier measures the change
in the money supply for a given dollar change in monetary base.
Actual money multiplier = Change in Money Supply ÷ Change in Monetary Base
Example 2: The Fed increases the monetary base by $150 million. The money supply increases
by $375 million. The actual money multiplier is 2.5 ($375 million ÷ $150 million = 2.5).
Tools for Controlling the Money Supply
The Fed has three major monetary policy tools available for controlling the money supply. The
most important monetary policy tool is open market operations. Open market operations refers to
the Fed buying and selling U.S. government securities in the open market.
The Federal Open Market Committee (FOMC) determines the policy for open market operations.
The voting members of the FOMC are the seven Federal Reserve Board Governors, the
president of the Federal Reserve Bank of New York, and four of the other eleven Federal
Reserve District Bank presidents, who serve on a rotating basis. The Chair of the Board of
Governors also serves as the Chair of the FOMC. Open market operations, along with the other
two monetary policy tools, are discussed below:
1. Open market operations. When the Fed makes a purchase or a sale, the monetary base
changes. When the monetary base changes, the money supply changes by a multiplied
amount. What the Fed primarily buys and sells is U.S. government securities. U.S.
government securities are an attractive asset for the Fed to hold for the same reasons (see
Chapter 10) that U.S. government securities are an attractive asset for banks to hold.
If the Fed wanted to increase the money supply, it would buy U.S. government securities in
the open market. If the Fed buys securities in the open market, bank reserves increase. When
bank reserves increase, banks have excess reserves, which they can loan out triggering the
money creation process. The money creation process leads to a multiplied expansion of the
money supply.
If the Fed wanted to decrease the money supply, it would sell U.S. government securities in
the open market. If the Fed sells securities in the open market, bank reserves decrease. When
bank reserves decrease, this leads to a multiplied contraction of the money supply. Open
market operations is the Fed’s most important tool for controlling the money supply.
FOR REVIEW ONLY - NOT FOR DISTRIBUTION
Example 3: The Fed buys $300,000 of U.S. government securities in the open market. The seller
is Bank X. The Fed pays Bank X for the securities by increasing Bank X’s deposit account
balance with the Fed by $300,000. Below is the updated balance sheet for Bank X from page 10-
The Federal Reserve System 11 - 2