Let's have a look at a super simplified example of what happens when a reserve bank performs an open market operation. The commercial bank below is the only bank in the country. The Reserve Bank in the country performs an open market operation, buying short term government debt instruments for 50, adjust the commercial bank's balance sheet to reflect this event. Well, first, we'll have a look at the assets of the bank Before this operation, the bank has cash and reserves at the Reserve Bank for 65, it has loans of 620. On the liability side, it has significant deposits and of course equity. So before this operation, the reserves are the cash and the reserves at the reserve bank divided by the deposits. So 10%. Now let's see what happens when the Fed makes its open market operation. Well, the first thing that's going to happen is that as the Fed is buying these securities, the seller of those securities are ending up with more cash in their pockets. Sooner or later, that cash will find its way back into the banking system. And because there's only one bank in this country, it's gonna end up a deposit in this bank. So deposits are going to go up.

So we'll start with the 650 deposits we had, and we'll add another 50. But that's not the end of the story. These deposits have now come into the bank, and of course, ended up as cash on the balance sheet on the asset side of the balance sheet. So cash would've increased as well going from the 65, it used to be to 115.

If we look at the reserve percentage now, that would've increased as cash, and the reserves at the reserve bank have gone up by the same absolute amount as the deposits and the reserves are now 16.4% to be exact. Now, of course, in the next step, this bank could now make more loans, bringing the reserve percentage back down towards 10%, again, thereby contributing to stimulating the economy.