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Difficulty: MediumMonetary Policy, Fiscal Policy, and Economic Tools

During a period of rapid economic expansion and rising inflation, policy authorities seek to tighten monetary conditions. Which of the following actions represents a monetary policy tool executed by the Federal Reserve to contract the money supply?

  1. Raising the interest rate paid on reserve balances (IORB)Answer
  2. B
    Increasing federal corporate and individual income tax rates
  3. C
    Purchasing U.S. Treasury securities from primary dealers in open market operations
  4. D
    Reducing federal government expenditure on public infrastructure projects

Answer

Raising the interest rate paid on reserve balances (IORB)
Raising the interest rate paid on reserve balances (IORB) is a primary monetary policy tool managed by the Federal Reserve. When the Fed raises the IORB rate, banks earn a higher risk-free return by keeping reserves at the central bank rather than extending loans to consumers or businesses. This reduces commercial lending activity, absorbs liquidity, and contracts the money supply to combat inflation.

Step-by-Step Solution

1
Distinguish between Federal Reserve monetary policy tools and Congressional fiscal policy tools.
Tax rate adjustments and government spending decisions are identified as fiscal policy tools controlled by Congress, eliminating options involving income tax hikes or infrastructure spending cuts.
The Federal Reserve does not have constitutional authority over federal taxation or budget spending.
2
Analyze the remaining Federal Reserve monetary policy tools for their effect on money supply growth.
Purchasing securities injects money into banks (expansionary/easy money), whereas raising the Interest on Reserve Balances (IORB) rate incentivizes banks to retain reserves at the Fed (contractionary/tight money).
To cool inflation, the Federal Reserve employs tight-money actions that absorb liquidity and raise short-term market rates.

Key Concept

Federal Reserve Monetary Policy Tools vs. Fiscal Policy Tools
Estimated Time:1m 15s
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Topics

Monetary Policy, Fiscal Policy, and Economic Tools

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