Question

In an open-market sale the Federal Reserve government bonds and the supply of bank reserves

A. buys - decreases
B. sells - increases
C. sells - decreases.
D. sells - does not change.
E. buys - increases

Answer 1

In an open-market sale, the Federal Reserve sells government bonds, which decreases the supply of bank reserves and the overall money supply, as opposed to buying bonds which would increase the money supply.

Step-by-step explanation:

In an open-market sale, the Federal Reserve sells government bonds which decreases the supply of bank reserves. This action results in money from individual banks in the economy flowing into the central bank, thereby reducing the quantity of money in the economy. Consequentially, this leads to a decrease in the total money supply circulating within the economy. Contrariwise, when the Federal Reserve buys bonds, it increases the money supply as money flows from the central bank to the banks in the economy, augmenting their reserves.

To provide a clear example, consider the case when Happy Bank purchases $30 million in bonds from the central bank. Happy Bank's reserves decrease by that $30 million since this amount is transferred to the central bank, but Happy Bank now also holds an additional $30 million in bonds. If Happy Bank’s desired reserve level is $40 million, it will then reduce the amount of its loans by $30 million to adjust its reserves back to the desired level.