Suppose the U.S.dollar appreciates in value against the Australian dollar, and the Fed intervenes in the foreign exchange market by using U.S.dollars to buy Australian dollars.The Fed could sterilize the expansionary effect of this intervention by:
A)buying U.S.dollars in the foreign exchange market.
B)buying U.S.government bonds in the domestic open market.
C)selling Australian dollars in the foreign exchange market.
D)selling U.S.government bonds in the domestic open market.
E)buying Australian dollars in the foreign exchange market.

Question

Quizplus · Accepted Answer

When the Fed intervenes in the foreign exchange market by using U.S. dollars to buy Australian dollars, it increases the supply of U.S. dollars in the market and decreases the supply of Australian dollars. This causes the value of U.S. dollars to fall and the value of Australian dollars to rise. To prevent this expansionary effect on the economy, the Fed can sterilize the intervention by selling U.S. government bonds in the domestic open market. This reduces the money supply in the economy, offsetting the increase in the money supply caused by the foreign exchange intervention. Therefore, buying U.S. dollars in the foreign exchange market, buying U.S. government bonds in the domestic open market, and selling Australian dollars in the foreign exchange market would not sterilize the expansionary effect of the intervention. Buying Australian dollars in the foreign exchange market would further increase the money supply in the economy, which would be counterproductive.