Question

3. How can the Federal Reserve use each of the three tools of monetary policy to fight inflation? How will these contractionary monetary policies (in theory) decrease aggregate demand?

Answer 1

Federal Reserve can use three tools of monetary policy to fight inflation. The three tools and their uses are -

Increasing Rates - Federal reserve can increase repo rates and thus the bank has to pay more for getting money from the Fed and their lending rates will also increase. Less investment as a result of this will decrease the aggregate demand since investment is a component of that.

Increasing Reserves - Federal reserve can increase the mandatory reserves for the banks and this will make less money available to them for lending. This slows the action. Less investment as a result of this will decrease the aggregate demand since investment is a component of that.

Increasing rates on government bonds - By this method, people start keeping their money in the form of government bonds due to higher returns on them. This sucks the money from the economy and inflation comes down. Less cash in the economy leads to less consumption thus decrease in the aggregate demand.