Suppose the Fed intervenes in the foreign exchange market by creating dollars to purchase Euros. The Fed could sterilize the effect of this intervention on the domestic money supply by
A) selling dollars in the foreign exchange market.
B) selling U.S. government bonds on the domestic open market.
C) buying Euros in the foreign exchange market.
D) buying U.S. government bonds on the domestic open market.
E) selling Euros in the foreign exchange market.

Question

Quizplus · Accepted Answer

When the Fed purchases Euros by creating dollars, it increases the domestic money supply. To sterilize this effect and prevent the money supply from increasing, the Fed can sell U.S. government bonds on the domestic open market. This action absorbs the excess liquidity, neutralizing the impact of the initial foreign exchange intervention on the domestic money supply.

Suppose the Fed Intervenes in the Foreign Exchange Market by Creating