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IAI Actuarial Core Principles · Business Economics · Impact of macroeconomic policies on businesses

The central bank buys government securities from banks in the open market as part of an expansionary policy. Which outcome is the most likely effect of this operation?

An open market purchase of securities injects reserves into the banking system, which tends to lower short-term interest rates and encourage bank lending to businesses. It is an expansionary tool, the opposite of selling securities, which would withdraw liquidity and push rates up.

  1. ABank reserves increase, short-term interest rates tend to fall and lending to businesses is encouragedCorrect
  2. BBank reserves decrease, short-term interest rates tend to rise and lending falls
  3. CThe money supply is withdrawn from the banking system
  4. DThe government's budget deficit is automatically eliminated
  5. The cash reserve ratio is raised

Explanation

When the central bank buys securities, it pays banks with reserves, so liquidity in the banking system rises. More liquidity pushes short-term rates down and makes it easier and cheaper for banks to lend to firms. Selling securities would have the opposite effect.

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