Final answer:
When inflation is a threat, the Federal Reserve aims to decrease the money supply through contractionary monetary policy. This often includes raising interest rates via increasing the discount rate or selling bonds to reduce the supply of money and credit in the economy.
Step-by-step explanation:
If inflation is a threat, then the Federal Reserve (the Fed) will conduct monetary policy aimed at decreasing the money supply. This is known as a contractionary monetary policy. The strategy involves the central bank decreasing the supply of money and credit in the economy, which in effect raises the interest rate, thereby discouraging borrowing for investment and consumption, and shifting the aggregate demand to the left. This results in a lower price level and, at least in the short run, a lower real GDP.
To carry out a contractionary policy, the Fed can raise the discount rate to discourage banks from borrowing reserves, or it can sell bonds to reduce the money supply. Both actions lead to higher interest rates, reducing investment and consumption, lowering inflation risks.