Question

A decrease in the money supply might indicate that the Fed had

a. purchased bonds to increase banks reserves.
b. purchased bonds to decrease banks reserves.
c. sold bonds to increase banks reserves.
d. sold bonds to decrease banks reserves.

Answer 1

d. sold bonds to decrease banks reserves.

Step-by-step explanation:

The Fed uses contractionary Open market operations to contain runaway inflation. The Fed sells bonds and securities to the banks to reduce the amount of money available for credit in the economy. The bank will use funds that should be loaned out to purchase government bonds, thereby denying individuals and firms a chance to borrow from the banks.

If the Fed wants to reduce the money supply in the economy, it issues out bonds and security at attractive interest rates. The banks will opt to invest with the government, which is risk-free rather than loan out to households and firms. By selling bonds and securities, the Fed mops out all the excess money in the economy.