Final answer:
When the Fed sells bonds during inflation, it conducts a contractionary monetary policy, leading to higher interest rates and a decreased money supply, which can mitigate inflation.
Step-by-step explanation:
When the Federal Reserve (Fed) sells bonds in the open market during a period of inflation, it is carrying out a contractionary monetary policy. The sale of bonds by the Fed increases the supply of bonds, which leads to lower bond prices and higher interest rates, according to the standard supply and demand dynamics for financial assets. When the interest rates rise, it tends to discourage borrowing by businesses and consumers due to the increased cost of borrowing. Concurrently, the action of selling bonds causes money to flow from individual banks back to the central bank, effectively reducing the money supply in the economy.
This reduction in the money supply is one mechanism by which the Fed can combat inflation. As borrowing becomes more expensive, spending and investment usually decrease, leading to a slowdown in the economy, which in turn can mitigate inflation. Furthermore, the higher interest rates can attract foreign investment into U.S. assets, strengthening the dollar and affecting the balance of trade. As a consequence, contrary to the options provided in the question, the correct outcome would be an increase in interest rates and a decrease in the money supply.