The Federal Reserve reacts to high inflation by
a. raising taxes.
b. raising interest rates.
c. lowering taxes.
d. lowering interest rates.
The correct answer and explanation is:
The correct answer is b. raising interest rates.
Explanation:
The Federal Reserve, or the Fed, is responsible for managing the nation’s monetary policy, primarily aiming to control inflation and stabilize the economy. When inflation is high, the Fed takes steps to reduce it and maintain price stability. One of the most effective tools at its disposal is the manipulation of interest rates, specifically the federal funds rate.
Raising interest rates is a key measure to curb inflation. When the Fed increases interest rates, borrowing becomes more expensive for both consumers and businesses. Higher interest rates discourage people from taking out loans and spending money, which leads to a decrease in overall demand for goods and services. As demand falls, the pressure on prices tends to ease, which can help reduce inflation.
Moreover, higher interest rates also make saving more attractive because the return on savings accounts, bonds, and other fixed-income investments increases. This encourages individuals and businesses to save rather than spend, further reducing overall demand in the economy.
In addition to controlling inflation, raising interest rates can have other effects, such as slowing down economic growth. However, in a situation where inflation is high, the priority is often to reduce price pressures, even if it means moderating economic expansion.
Other options like raising or lowering taxes are not directly within the control of the Federal Reserve. Tax policies are typically handled by the government through fiscal policy, not monetary policy. Lowering interest rates, on the other hand, would be used in the opposite situation when the economy is slow, and the Fed is trying to stimulate economic activity, not when inflation is a concern.