Question

To contract the economy with open market operation, the federal reserve will

Group of answer choices

increase reserve requirements

increase discount rates

buy T-bonds from banks

sell T-bonds to banks

Answer 1

The correct answer is D) Sell T bonds to banks.

Explanation of each part

Let us first discuss what is an open market operation(OMO). It refers to buying and selling of bonds in the open market with an aim to regulate money supply in an economy.

A) Now increase in reserve requirements has nothing to do with OMO as their is no buying and selling of bonds. However, if federal reserve decides to increase reserves, then there will be reduced money supply in an economy and will result in contraction. But we are talking about OMO specifically, so this is not a correct option.

B) Similarly, increases in discount rate has nothing to do with OMO. However, if rates are increases than it will induce banks to deposit money to the federal reserve as it is offering higher rates of returns that what market is offering to banks. Hence, it will result in contraction of money supply.

C) Buying of T bonds means that federal is giving their money in the economy and buying T bonds. This will expand money supply.

D) Selling of T bonds means that federal is asking for money in exchange of bonds from the bank. This will reduce the money and contract the money supply. Hence, the correct answer is selling of t bonds.