NASAA Series 65, Uniform Investment Adviser Law ExaminationEconomic Factors and Business InformationMedium
A central bank is concerned about an overheated economy with high inflation. Which of the following actions would it most likely take to cool down the economy?
- ALower the reserve requirement for banks.
- BPurchase government securities in the open market.
- CIncrease the discount rate.
- DReduce the federal funds target rate.
Show answer & explanationAnswer & explanation
Correct answer: C. Increase the discount rate.
To cool down an overheated economy and combat inflation, a central bank implements contractionary monetary policy. Increasing the discount rate makes borrowing more expensive for banks, reducing the money supply.
Why the other options are wrong
- A. Lowering the reserve requirement is an expansionary policy, increasing the money supply.
- B. Purchasing government securities (quantitative easing) is an expansionary policy, injecting money into the economy.
- D. Reducing the federal funds target rate is an expansionary policy, making interbank lending cheaper and increasing the money supply.
Contractionary Monetary Policy
Actions taken by a central bank to decrease the money supply and credit in an economy, typically to combat inflation.
- Aims to slow down economic growth and reduce inflation.
- Tools include increasing interest rates (discount rate, federal funds rate) and selling government securities.
- Often used when the economy is 'overheated'.
Memory trick: Interest Rates, Reserves, Open Market Operations: The three levers of the money machine.