Question

Samantha is a newly appointed member of the Federal Reserve. If inflation is​ increasing, it is likely that Samantha and her colleagues will recommend that the Fed​_____.

A.

decrease the reserve requirement

B.

limit check processing

C.

increase the discount rate

D.

limit foreign currency transactions

E.

buy Treasury notes and bonds

Answer 1

The correct answer is Option (C) Increase the discount rate

Explanation -

When inflation is increasing, the fed needs to pursue contractionary monetary policy. The key policy tools available with the fed are open market operations, discount rate alteration and reserve requirement alteration. In contractionary monetary policy, the fed increases the discount rates, sells Treasury notes and bonds or increases the reserve requirement. All these steps reduce money supply in the banking system and take interest rates (cost of money ) higher. This helps in curbing inflation.

Specifically, discount rate is the rate at which the fed lends to the banks. When the fed increases the discount rate, banks are less likely to borrow from the fed and this helps in curbing the money supply. In turn, inflation is controlled through lower credit growth arising from higher cost of money (interest rates).