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Difficulty: MediumMonetary Policy, Fiscal Policy, and Economic Tools

To address accelerating inflation during an economic expansion, policy makers evaluate various levers to reduce circulating liquidity and cool market activity. Which of the following actions represents a direct monetary policy tool utilized by the Federal Reserve to tighten credit conditions?

  1. Increasing the Interest on Reserve Balances (IORB) rate paid to depository institutionsAnswer
  2. B
    Increasing federal corporate and personal income tax rates to decrease private sector spending
  3. C
    Relying on changes in the average duration of unemployment as a primary leading economic indicator to time policy tightening
  4. D
    Purchasing long-term Treasury bonds in open market operations to invert the yield curve as a sign of economic expansion

Answer

Increasing the Interest on Reserve Balances (IORB) rate paid to depository institutions
Increasing the Interest on Reserve Balances (IORB) rate is a modern core monetary policy tool executed directly by the Federal Reserve. By increasing the rate paid to banks holding excess reserves at the Fed, the central bank establishes a higher risk-free benchmark, prompting banks to raise commercial lending rates and restrict credit expansion throughout the financial system.

Step-by-Step Solution

1
Identify the institutional origin of the tool
Distinguish Federal Reserve monetary policy tools (IORB, discount rate, reserve requirements, open market operations) from Congressional fiscal policy tools (taxation, government spending).
Monetary policy is managed independently by the Federal Reserve, while fiscal policy is enacted by legislative and executive government branches.
2
Determine the operational mechanism required to achieve the objective
Raising the IORB rate encourages banks to retain excess reserves at the Fed, contracting credit creation and raising short-term interest rates.
Higher interest paid on reserves acts as a floor for short-term market rates and curtails commercial lending to combat inflationary pressures.

Key Concept

Federal Reserve Monetary Policy Tools vs. Fiscal Tools
Estimated Time:1m 0s
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Topics

Monetary Policy, Fiscal Policy, and Economic Tools

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