When conducting an open-market sale, the Fed:

When conducting an open-market sale, the Fed:

a. sells government bonds, and in so doing increases the money supply.

b. sells government bonds, and in so doing decreases the money supply.

c. buys government bonds, and in so doing increases the money supply.

d. buys government bonds, and in so doing decreases the money supply.

Answer: b. sells government bonds, and in so doing decreases the money supply.

When the Federal Reserve sells bills in an open market operation, it can simply offer government bonds to banks or other financial institutions. Thus, this action essentially drains money out of circulation in the economy and, therefore, decreases that supply. Here’s how it works: This operation is special in a way that when banks buy these bonds they do that with the reserves that they hold. This means the amount of funds available to banks to lend to citizens and other borrowers, is brought down. The actual amount of stock of money in circulation reduces since the amount of money put as deposits reduces hence reducing the amount of money available for lending. This is a monetary policy tool used by the Fed to influence supply-side inflation and check on growth. To slow a booming economy or lower inflation rates the amount of money in circulation must be reduced and this is all done by the Federal Reserve.