Chapter 27, Problem 4MCQ

To determine

The question is asking us to determine the effect on bank reserves and money supply when the federal reserve purchases Treasury Bills from commercial banks.

Explanation of Solution

One of the core functions of the federal reserve in an economy is to regulate the money supply to control inflation and deflation. The Federal Reserve does so by regulating the money supply in the market overall. One way to regulate the money supply of the Federal Reserve is to buy or sell Treasury securities from or to the commercial banks which operate under their supervision.

The economic phenomenon under this is very simple. The commercial banks will be selling their holdings to the federal reserve and in return, the federal reserve will provide them with money. This transaction will lead to more money supply to the commercial banks and in return, the commercial banks can lend more money to the general public resulting in an overall increase in the supply of money.

Thus, from the above explanation, we can conclude that the correct option is B.