When the Federal Reserve buys government bonds in the open market, what happens to the supply of money in the economy?

• A. It becomes unpredictable.
• B. It remains unchanged.
• C. It increases.
• D. It decreases.

Answer: (C)

Verified step by step guidance

1. Understand the role of the Federal Reserve in open market operations: When the Fed buys government bonds, it pays for these bonds by adding funds to the reserve accounts of commercial banks.
2. Recognize that this payment increases the reserves of banks, which means banks have more money to lend out to businesses and consumers.
3. Recall that an increase in bank reserves typically leads to an increase in the money supply because banks can create money through the lending process (money multiplier effect).
4. Conclude that when the Fed buys government bonds, the supply of money in the economy increases as more funds become available for lending and spending.
5. Therefore, the correct understanding is that open market purchases by the Fed lead to an increase in the money supply.