An open-market sale by the central bank primarily has which effect on the money supply and the nominal interest rate in the short run?

• A. Money supply decreases; nominal interest rate rises in short run.
• B. Money supply increases; nominal interest rate falls in short run.
• C. Money supply unchanged; nominal interest rate unchanged.
• D. Money supply decreases; nominal interest rate falls in short run.

Answer: (A)

Open-market operations are how the central bank changes the money supply. When it conducts an open-market sale, it sells government bonds to banks or the public. Payment comes out of bank reserves, so reserves fall. With fewer reserves, banks can create fewer deposits through lending, shrinking the overall money supply. In the short run, a tighter money supply makes funds scarcer, so the price of borrowing—nominal interest rates—rises. So the expected outcome is a decrease in the money supply and an increase in the nominal interest rate.

The alternative outcomes would require the opposite action (increasing money supply or keeping it unchanged) or would need rates to fall despite a sale, which isn’t consistent with how open-market sales tighten liquidity.