Consider the scenario where we are in a low interest rate period for a really long time. Now, inflation is expected to increase over the next few months. What decision might the Federal Reserve consider to combat inflation? (choose all that apply)
A) The Fed will probably lower interest rates
B) The Fed want the money supply to decrease in order for interest rates to increase
C) The Fed will print more money
D) The Fed will increase the reserve requirements ratio
The correct answer and explanation is:
The correct answer is: B) The Fed wants the money supply to decrease in order for interest rates to increase and D) The Fed will increase the reserve requirements ratio.
Here’s the explanation:
When inflation is expected to rise, the Federal Reserve may take actions to combat this by tightening the money supply. Tightening the money supply is aimed at reducing inflationary pressures. One of the ways the Fed can do this is by increasing interest rates, which helps to reduce borrowing and slow down economic activity. But to achieve this increase in interest rates, the Fed would first need to decrease the money supply.
To decrease the money supply, the Fed can increase the reserve requirements ratio. The reserve requirements ratio is the percentage of depositors’ funds that banks are required to hold in reserve rather than lend out. By increasing this ratio, the Fed effectively reduces the amount of money banks have available to lend, thus reducing the money supply. This reduction in the money supply, in turn, leads to an increase in interest rates because there is less money available for borrowing.
Option A, “The Fed will probably lower interest rates,” is incorrect in this case because lowering interest rates would likely increase inflation rather than control it. Lower interest rates make borrowing cheaper, which can lead to more spending and, therefore, higher demand in the economy, which pushes prices up.
Option C, “The Fed will print more money,” is also incorrect. Printing more money would increase the money supply, which could worsen inflation. This is a tactic that could be used in a situation where the Fed is trying to stimulate the economy during a recession, but it is not a strategy for combating rising inflation.
In summary, to control rising inflation, the Federal Reserve would likely focus on reducing the money supply by increasing the reserve requirements ratio and raising interest rates, not by printing more money or lowering interest rates.