Final answer:
The correct answer is D. Repos and reverse repos. These are collateralized loans used by the Federal Reserve to manage liquidity and influence the money supply. Banks can also hold assets like bonds and reserves to mitigate risk and ensure economic stability.
Step-by-step explanation:
The correct answer to the student's question is D. Repos and reverse repos. These are financial instruments used by the Federal Reserve (often referred to as the Fed) to influence the money supply, which in turn can impact interest rates and the broader economy. A repo, or repurchase agreement, is essentially a short-term loan. In a repo, banks sell government securities to the Fed with an agreement to buy them back at a slightly higher price at a later date. The difference in price acts as the interest on the loan. A reverse repo is the opposite; the Fed sells government securities to a bank with the agreement to repurchase them later. These tools help the Fed manage liquidity and control the reserve levels of commercial banks, thereby adjusting the money supply.
Banks can also reduce risks related to loan defaults by diversifying their loan portfolios and holding a larger share of assets in the form of government bonds or reserves. In recessionary periods, a bank's net worth may decline due to customers' inability to repay loans, but holding bonds and reserves provides some security. This strategy complements the Fed's monetary policy tools like repos and reverse repos in managing economic stability.