DSST Money & Banking Practice Exam 2026 - Free Money & Banking Practice Questions and Study Guide

When the Federal Reserve buys securities from banks, it effectively injects liquidity into the banking system. This process is a key component of expansionary monetary policy. When the Fed purchases securities, it credits the banks' reserves with additional funds, which increases the amount of money that banks can lend. This addition to bank reserves enhances the overall money supply in the economy.

The increase in the money supply occurs because banks can now lend out more money. Since banks are required to hold only a fraction of deposits as reserves (as per reserve requirements), an increase in reserves allows them to create more loans. These loans, in turn, can be deposited back into the banking system, leading to a multiplied increase in the money supply through the process known as fractional reserve banking.

Thus, when the Fed buys securities from banks, the immediate effect is an increase in bank reserves, which translates into an overall increase in the money supply available for lending and spending in the economy.