Question

Assuming that the Fed judges inflation to be the most significant problem in the economy and that it wishes to employ all of its policy instruments except interest on reserves, what should the Fed do with its policy tools

Answer 1

Sell securities in the open market.

Increase discount rate.

Increase required reserve ratio.

Step-by-step explanation:

Apart from interest on reserves the other tools that the Fed can use to control money supply are open market operations, discount rate, and required reserve ratio.

In order to reduce inflationary pressures, the fed needs to reduce the money supply in the economy. For this, the fed needs to sell government securities in the open market. This will reduce the reserves with reserves and their credit creation power. As a result, the money supply will get reduced as well.

Other than that the fed increase the discount rate, this will make borrowing from feds expensive for the commercial banks. This will also help in reducing the money supply as the bank's reserve will get reduced.

The fed can also increase the required reserve ratio. So the banks will need to keep a greater portion of their total reserves as required reserves. They will be able to create less credit so the money supply will get reduced.