Final answer:
Purchases of securities by the Federal Reserve increase the money supply by providing banks with additional reserves to loan out, triggering a money multiplier effect. Sales of securities, conversely, reduce the money supply as they draw funds out of the banking system and into the central bank.
Step-by-step explanation:
When the Federal Reserve purchases securities in the open market, it essentially injects money into the banking system. This increase in money flows into individual banks, which then have more reserves. Happy Bank, as an example, had $460 million in assets, with $400 million in deposits. With a purchase of $20 million in bonds by the Federal Reserve from Happy Bank, its bond holdings decrease but its reserves increase by the same amount. Happy Bank then loans out these additional reserves, which leads to a multiplication of the money supply as loans are redeposited and re-loaned across the banking system.
On the other hand, when the Federal Reserve sells bonds, money is transferred from the banks back to the central bank, effectively reducing the money supply in the economy. This operation would lead to Happy Bank and similar institutions tightening their lending activities, thereby contracting the supply of money.