Question

Suppose the Fed intervenes in the foreign exchange market by creating dollars to purchase Euros. The Fed could sterilize the effect of this intervention on the domestic money supply by:

a) selling dollars in the foreign exchange market.
b) selling U.S. government bonds on the domestic open market.
c) buying Euros in the foreign exchange market.
d) buying U.S. government bonds on the domestic open market.
e) selling Euros in the foreign exchange market.

Answer 1

To sterilize the effect of creating dollars to purchase Euros on the domestic money supply, the Fed would sell U.S. government bonds on the domestic open market, which absorbs excess liquidity.

Step-by-step explanation:

When the Federal Reserve (the Fed) intervenes in the foreign exchange market by creating dollars to purchase Euros, it increases the money supply, which can be inflationary. To sterilize the effect of this intervention on the domestic money supply and prevent inflation, the Fed needs to conduct a sterilization operation. The correct action would be b) selling U.S. government bonds on the domestic open market. This action absorbs the excess liquidity in the economy because investors who buy these bonds pay for them with cash, which is then removed from circulation.