Suppose the Fed intervenes in the foreign exchange market by buying Euros with U.S. dollars. To offset the effect of the intervention on the domestic money supply, the Fed has to purchase U.S. government bonds on the domestic open market.

Question

Quizplus · Accepted Answer

When the Fed buys Euros with U.S. dollars, it increases the supply of dollars in the foreign exchange market, potentially affecting the domestic money supply. To offset this effect and avoid increasing the money supply, the Fed would sell U.S. government bonds in the domestic open market, not purchase them. Selling bonds absorbs dollars from the economy, counteracting the increase in money supply caused by buying Euros.

Suppose the Fed Intervenes in the Foreign Exchange Market by Buying