Question

If you were a member of the Federal Reserve board of​ governors, and you saw that the economy was sliding into a​ recession, which of the following actions would you MOST likely​ recommend?

A.

Sell U.S. government bonds in open market operations.

B.

Raise the discount rate.

C.

Implement fiscal policy.

D.

Raise the reserve requirement.

E.

Buy U.S. government bonds in the open market.

Answer 1

The correct answer is (E) Buy U.S. government bonds in the economy.

It is given that economy was sliding into a recession. This means that Federal reserve should set those policies which results in increase in Real output and this is possible when AD curve shifts to the right. AD(aggregate demand) curve will shift to the right when LM curve shifts to the right. LM Curve shifts to the right when money supply increases. One of the main thing by which one can increase money supply is by using open market purchase in which Federal reserve purchases government securities which result in more liquidity in the economy which results in increase in reserves of Banks and thus more money will be created in the market and hence money supply will increase and this will shift LM curve to the right  which further shift AD curve to the right and hence increase aggregate output in the economy. Hence purchasing government bonds will be recommended and hence option (E) is the correct answer and option (A) is incorrect.

Discount rate is the rate at which fed provide loan to commercial bank and if this rate increases, commercial bank will take less loans and thus decreases liquidity and money supply in the economy. But we want to increase money supply and hence option (B) is also incorrect.

Fiscal polity is not in a hand of Federal Reserve and thus is incorrect and hence option (C) is also incorrect.

Money Multiplier is inversely related to Reserve requirements ratio. Thus if required reserve ratio increases then money multiplier will decrease and hence Banks will now able to create lemm amount of money and hence money supply will decrease. Thus option (E) is also incorrect.

Hence, the correct answer is (E) Buy U.S. government bonds in the economy.