Final answer:
Purchasing bonds during open market operations leads to a use of funds and a reduction in a bank's cash reserves. Happy Bank would reduce its loan quantity to maintain desired reserve levels, impacting cash balances and the broader money supply.
Step-by-step explanation:
When a bank engages in open market operations and purchases bonds, it results in a use of funds and a reduction in its cash reserves. For example, if Happy Bank buys $30 million in bonds, it must send $30 million of its cash reserves to the central bank, receiving bonds in return.
Nevertheless, if Happy Bank’s policy is to maintain $40 million in reserves, the institution will reduce the quantity of its loans by $30 million to rebalance its reserves. This process results in a reduction in cash balances because the bank has less liquidity due to the bond purchase and the adjustment in loans.
Furthermore, this action affects the overall money supply in the economy. A reduction in loans from one bank leads to fewer deposits in others, and correspondingly, other banks may reduce their lending. This cascading effect ties back to the concept of the money multiplier covered in money and banking discussions.