Question

What happens when the Fed sells bonds in the open market, and at the same time, we experience a recession?

A) Interest rates rise, and the money supply decreases
B) Interest rates rise, and the money supply increases
C) Interest rates fall, and the money supply decreases
D) Interest rates fall, and the money supply increases

Answer 1

When the Fed sells bonds, the money supply decreases and interest rates rise due to funds moving from the banks into the central bank. This activity can lead to tighter economic conditions, particularly during a recession.

Step-by-step explanation:

When the Federal Reserve (Fed) sells bonds in the open market, it is conducting a contractionary monetary policy, which leads to a reduction in the money supply and higher interest rates. This is because money flows from the banks into the central bank in exchange for the bonds, effectively removing that money from the banking system and reducing the amount available for lending.

The increased demand for remaining funds pushes interest rates upward. During a recession, this could exacerbate the economic downturn by making it more expensive for businesses and consumers to borrow. However, the Fed typically lowers interest rates during a recession to stimulate borrowing and spending.

In the scenario provided, where the Fed is selling bonds during a recession, the correct answer to what happens would be: A) Interest rates rise, and the money supply decreases.