Final answer:
To increase the money supply, a central bank will buy bonds in open market operations. This injects money into the banking system, allowing for an increase in bank lending and expanding the money supply.
Step-by-step explanation:
A central bank's decision to increase the quantity of money in the economy is a strategic move typically achieved through open market operations, which is a fundamental component of monetary policy. When the central bank aims to boost the money supply, it engages in the purchase of government bonds in the open market.
This process involves the central bank buying bonds from financial institutions, injecting money directly into the banking system. As the central bank acquires government bonds, it credits the accounts of the selling banks, thereby increasing their reserves. With higher reserves, banks have the capacity to extend more loans to businesses and individuals. This, in turn, contributes to an expansion of the overall money supply in the economy.
The central bank's ability to influence the money supply through open market operations is a powerful tool in monetary policy. By adjusting the volume of government bonds held, the central bank can effectively manage the level of reserves in the banking system and, consequently, control the quantity of money circulating in the economy.
Conversely, if the central bank seeks to reduce the money supply, it may opt to sell government bonds. This action withdraws money from the banking system, diminishing reserves and, subsequently, limiting the capacity of banks to extend loans. Through these open market operations, central banks aim to maintain price stability, control inflation, and promote economic growth by managing the money supply in the financial system.