Question

Explain how an open market sale decreases the money supply.

Short answer

An open market sale decreases the money supply by selling bonds to commercial banks, reducing their reserves and limiting the amount of funds available for lending. Reduced money supply usually increases interest rates, further discouraging borrowing and contributing to a tighter money market.

Step-by-step solution

Understanding Open Market Operations

Open Market Operations are the buying and selling of government bonds by a central bank to control the amount of money in the economy. In this case, the central bank is selling bonds in an open market operation.

Effect on Money Supply

An open market sale of bonds by the central bank decreases the money supply. That's because, to buy the bonds, commercial banks uses their reserves, which decreases the amount of money they have available. This means less money can be offered as loans to people and businesses, thereby decreasing the overall money supply.

Effect on Interest Rates

The decrease in money supply usually results in an increase in interest rates because there is less money available for lending. This encourages saving and discourages borrowing, further contributing to the decrease in the money supply.

Conclusion

Therefore, by selling securities in open market operations, the monetary authority can decrease the money supply, making money more expensive and borrowing less attractive.