What is the impact on interest rates when the Federal Reserve decreases the money supply by selling bonds to the public?

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BlackTom AI · Accepted Answer

The question asks about the impact on interest rates when the Federal Reserve decreases the money supply by selling bonds to the public.

First, consider what happens in an open market operation: when the Fed sells government bonds, buyers pay money to the Fed, which reduces the amount of money circulating in the economy. This withdrawal of reserves from the banking system tends to raise the federal funds rate and, more broadly, short-term interest rates.

Next, think about the transmission mechanism: with less money available, the supply of loanable funds decreases. Lenders can charge higher rates because the cost of funds for banks and other borrowers has risen, and the demand for credit remains, so prevailing interest rates move up.

Additionally, higher interest rates tend to crowd out some investment and spending, reinforcing the tightening effect the Fed intended by the contraction of the money supply.

Consider potential alternative interpretations: 
- If someone argued that rates fall due to selling bonds, that would ignore the money-supply channel and the balance-sheet effects on reserves, which is inconsistent with standard monetary theory. 
- If someone claimed no change in rates, they would be neglecting the immediate impact on liquidity and the signaling effect about monetary policy. 
- If someone suggested long-term rates would necessarily fall regardless of the initial liquidity shift, that would overlook the immediate shortage of funds and the typical upward pressure on rates in the short run.

In summary, the conventional view is that an open-market sale by the Fed reduces the money supply, tightens liquidity, and leads to higher prevailing interest rates in the short run as the demand for funds outpaces the reduced supply.

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What is the impact on interest rates when the Federal Reserve decreases the money supply by selling bonds to the public?

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