Question

What action can the Federal Reserve take to reduce inflation?

Answer 1

Federal reserve controls inflation with the help of monetary policy. It uses contractionary monetary policy to reduce the money supply which reduces inflation and economic growth.

Tools to control inflation-

1. Open market operations- Fed sells securities typically Treasury Bills which the member banks are forced to buy. This reduces money supply, banks have less money to lend and inflation reduces.

2. Fed can raise reserve requirement- Reserve requirement is the minimum reserves that banks must keep with themselves out of the total deposits. When Fed raises this reserve requirement, banks have less to lend out. Hence money supply and inflation falls.

3. Fed can raise discount rate- It is the interest rate Fed charges from banks to borrow funds. When it rises, borrowing becomes expensive. Hence money supply and inflation falls.

4. Fed can change Federal funds rate- It is the interest rate banks charge other banks for lending them money to maintain the reserve requirement. When it rises banks find it difficult to borrow hence they try to maintain the reserve requirement on their own. Fed controls this rate by controling the money supply.