Assume the money supply is backed by bonds and reserves, and the exchange rate is pegged. If the domestic demand for money falls, what happens to the level of bonds and reserves?
A) The level of bonds and reserves both rise.
B) The level of bonds stays the same, while the level of reserves falls.
C) The level of bonds rises, while the level of reserves falls.
D) The level of bonds falls and the level of reserves rises.

Question

Quizplus · Accepted Answer

If the demand for money falls, people will tend to hold onto less money, which means banks will have excess reserves. As a result, the level of reserves will fall. However, if the money supply is backed by bonds and reserves, the central bank can sell bonds to banks in order to increase their reserves, which will stabilize the money supply. Therefore, the level of bonds stays the same, while the level of reserves falls.

Assume the Money Supply Is Backed by Bonds and Reserves