Final answer:
If the Federal Reserve sells $25 billion in securities, they decrease banks' reserves, as banks pay for these securities. Banks like Acme then reduce loans to maintain reserve requirements, resulting in a decrease in the money supply, specifically M1.
Step-by-step explanation:
When the Federal Reserve sells government securities, it is conducting what is known as an open market operation, which is a tool used to manage the money supply and banking reserves. In the hypothetical scenario where the Federal Reserve sells $25 billion worth of securities, they are implementing a contractionary monetary policy. The sale of securities to a bank, such as Acme Bank, results in a transfer of money from the bank to the Fed, decreasing the bank's reserves.
Looking at the balance sheet of Acme Bank that initially shows $30 million in reserves, $50 million in bonds, and $250 million in loans, with deposits of $300 million and equity of $30 million, when the Fed sells $10 million in Treasury bonds to the bank, Acme's reserves would decrease by $10 million as they buy the bonds. Since Acme needs to maintain a 10% reserve requirement, they would then have to adjust by reducing loans to bolster back reserves. This action, in turn, reduces the money supply, particularly M1, which consists of physical currency and demand deposits like checking accounts.