When the Fed sells government bonds the money supply increases and the federal funds rate decreases. True False
The correct answer and explanation is:
False.
When the Federal Reserve (Fed) sells government bonds, the money supply decreases and the federal funds rate increases, not the other way around. Here’s how it works:
The Federal Reserve uses the sale of government bonds as a tool to control the money supply in the economy. When the Fed sells bonds to commercial banks or other financial institutions, it takes money from these banks in exchange for the bonds. This reduces the amount of money available in the banking system because the money used by the banks to purchase the bonds is no longer available for lending or other activities.
As a result, the reduction in the money supply puts upward pressure on interest rates, including the federal funds rate, which is the interest rate at which banks lend to each other overnight. With less money available in the system, banks become more reluctant to lend, and the cost of borrowing (i.e., the interest rate) increases.
The decrease in the money supply and the increase in interest rates are part of a contractionary monetary policy, which is often used by the Fed when it wants to slow down economic activity, reduce inflation, or control excessive growth in the economy. By selling bonds, the Fed essentially makes it more expensive for businesses and consumers to borrow money, leading to a cooling of economic activity.
To summarize, when the Fed sells government bonds, the money supply contracts and interest rates, including the federal funds rate, typically increase.