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Chapter 13: Problem 4

Explain how an open market sale decreases the money supply.

Short Answer

Expert verified
An open market sale decreases the money supply by selling bonds to commercial banks, reducing their reserves and limiting the amount of funds available for lending. Reduced money supply usually increases interest rates, further discouraging borrowing and contributing to a tighter money market.

Step by step solution

01

Understanding Open Market Operations

Open Market Operations are the buying and selling of government bonds by a central bank to control the amount of money in the economy. In this case, the central bank is selling bonds in an open market operation.
02

Effect on Money Supply

An open market sale of bonds by the central bank decreases the money supply. That's because, to buy the bonds, commercial banks uses their reserves, which decreases the amount of money they have available. This means less money can be offered as loans to people and businesses, thereby decreasing the overall money supply.
03

Effect on Interest Rates

The decrease in money supply usually results in an increase in interest rates because there is less money available for lending. This encourages saving and discourages borrowing, further contributing to the decrease in the money supply.
04

Conclusion

Therefore, by selling securities in open market operations, the monetary authority can decrease the money supply, making money more expensive and borrowing less attractive.

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Most popular questions from this chapter

Explain how an open market purchase increases the money supply.

Suppose you read in the newspaper that all last week the Fed conducted open market purchases and that on Tuesday of last week it lowered the discount rate. What would you say the Fed is trying to do?

The Fed can change the discount rate directly and the federal funds rate indirectly. Explain.

Identify the major responsibilities of the Federal Reserve System.

Suppose Bank A borrows reserves from Bank B. Now that Bank A has more reserves than previously, will the money supply increase? Explain your answer.
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