Question

When the Fed sells government securities, the banks':

A. reserves will increase and lending will expand causing an increase in the money supply.
B. reserves will decrease and lending will contract causing a decrease in the money supply.
C. reserve requirements will increase and lending will contract causing a decrease in the money supply. D. reserves/deposit ratio will increase and lending will expand causing an increase in the money supply.

Answer 1

The correct answer is option B.

Step-by-step explanation:

When the Federal reserve bank sells government securities, the banks will purchase them and pay back fed. This payment is made out of banks' reserves. This causes the reserves to decrease.

As reserves decline, the banks will be able to provide fewer loans. Consequently, this decrease in lending will further cause the money supply to decrease.