Fed open market purchases of Treasury securities _____ interest rates and _____ the money supply.

• A. Lower; decrease
• B. Raise; increase
• C. Lower; increase
• D. Raise; decrease

Answer: (C)

Buying Treasuries in open market operations pumps reserves into banks, expanding the monetary base. With more reserves, banks can lend more, which increases the money supply. That extra supply of loanable funds puts downward pressure on short-term interest rates, so they fall. Therefore, open market purchases lower interest rates and increase the money supply.

The other patterns don’t fit this mechanism: a scenario with higher rates would typically come with a tighter money supply, and a scenario with a decreasing money supply would not accompany lower rates. The only combination that matches the flow from more reserves to more lending and cheaper borrowing is lower interest rates and an increased money supply.