Question

Suppose we are currently at the natural level of output, but the Federal Reserve believes that the current rate of inflation is too high. Explain what the Fed will have to do in order to reduce the rate of inflation, but nevertheless have the economy return to the natural level of output.

Answer 1

During inflation Fed use monetary policy tools to reduce the rate of inflation. these tools include open market, asset purchases, reserve regulation, discount lending. The main steps that would be taken by Fed are: 1. Lowers the federal funds rate: this frees up more money for banks, allowing them to offer more attractive loans. 2. Reduce the reserve ratio: as if banks dont have to keep high percentage of their assets in reserves, then they will have more money, this will led to molre facilities of loans to general public or customers. 3. Lowers the discount rate: this will led to frees up of money for banks which are borrowing money from Fed. after this money is passed to the bank's customers. 4. Use its own reserve money to buy govt. bond: buying bonds actually translates to income for the US government, which will put more money into the economy.