How Does an Open Market Sale by the Federal Reserve Affect the Money Supply?

What is the impact of an open market sale by the Federal Reserve on the money supply?

Which of the following choices accurately describes the effect of an open market sale by the Fed on the money supply?

A. Increase bank reserves.

B. Increase currency held by the public or vault cash.

C. Increase the money supply.

D. Reduce the money supply.

Answer

The correct answer is option D - Reduce the money supply.

When the Federal Reserve conducts an open market sale, it involves offering to sell Treasury bills or bonds to investors, commercial institutions, or the general public. This move lowers the amount of money that is readily available in the economy, which reduces the money supply.

Here is how an open market sale affects the money supply:

Selling of government securities: The Federal Reserve sells securities to market players through auctions, withdrawing cash from circulation to purchase these securities.

Decrease in bank reserves: Market participants use money from their bank accounts to pay for government securities, leading to a decrease in bank reserves.

Reduced lending capacity: With lower reserves, commercial banks have less capacity to lend, potentially slowing down economic activity.

Decrease in the money supply: As money is taken out of circulation to purchase securities, the overall money supply decreases, affecting currency held by the public and bank reserves.