An open market sale by the Federal Reserve ______ the monetary base and ______ the size of the Fed's balance sheet.

Question

BlackTom AI · Accepted Answer

When evaluating what happens during an open market sale by the Federal Reserve, it's helpful to walk through the mechanics and their effects on the balance sheet and monetary base.
Option 1: 'decreases, decreases' — This is the correct framing. Selling securities to financial institutions drains reserves from the banking system, which lowers the monetary base (the sum of currency in circulation and bank reserves). With fewer reserves, the Fed’s asset side (securities) and the corresponding liability side (reserves) both shrink, so the Fed's balance sheet size decreases as well.
Option 2: 'decreases, does not change' — This would imply the monetary base falls while the size of the Fed’s balance sheet stays the same. In reality, when the Fed sells securities, its assets decline (securities shrink) and its liabilities (reserves) also decline, so the balance sheet changes.
Option 3: 'decreases, increases' — A decrease in the monetary base is paired with an increase in the Fed’s balance sheet size, which contradicts the effect of selling assets. The act reduces assets and typically reduces liabilities, not increases them.
Option 4: 'increases, decreases' — An open market sale would not increase the monetary base; it reduces it. Therefore this pairing is incorrect.
Option 5: 'increases, does not change' — Increasing the monetary base is opposite to what happens during a sale, and claiming the balance sheet does not change is inconsistent with the decline in both assets and reserves.
Option 6: 'increases, increases' — Both the monetary base and the balance sheet size would not rise as a result of a sale; both typically contract, making this option inaccurate.
In summary, the mechanism of selling securities to reduce reserves directly leads to a smaller monetary base and a smaller Fed balance sheet, which aligns with option 1 and contradicts all other pairings.

An open market sale by the Federal Reserve the monetary base and the size of the Fed's balance sheet.Single choice

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