Question

Describe one tool used by the Federal Reserve (reserve requirements, open market operations,paying interest on excess reserves, or the discount rate) and state how the Fed would use that tool to counteract rapidly rising prices.

Answer 1

Banks are required to maintain a certain portion of their deposits as a reserve. These are called Reserve requirements. These are the portions of deposits that banks must hold in cash, either in their treasuries or on deposit at a Reserve Bank.

A decrease in reserve requirements implies that there is an increase in the funds available in the banking system to lend to consumers and businesses. An increase in reserve requirements is contractionary because it reduces the funds available in the banking system to lend to consumers and businesses. In this way, Federal Reserve controls the quantity of money in circulation.

For example: If Federal Reserve orders banks to hang on to 1% of their deposits, they would then have 1% less to lend the customers.