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The Federal Reserve Bank is worried about an increase in the interest rate due to federal...

The Federal Reserve Bank is worried about an increase in the interest rate due to federal government budget deficits. What can the Federal Reserve do to offset the increase in the interest rate? What is the tradeoff of offsetting the increase in the interest rate?

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Answer #1

The aim of the federal reserve should be to reduce the rate of interest. This can happen when the federal reserve

  • Conduct open market purchase of government securities and increase the bank reserves
  • reduce the required reserve ratio in order to increase bank reserves
  • Reduce the discount rate to increase bank reserves

Increasing bank reserves is important because it will increase loan generation and put a downward pressure on the interest rate.

The obvious trade-off is an increase in the price level which means higher inflation. It may also destabilizes the output because lower interest rate will increase investment and increase aggregate demand.

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