Question

When the Federal Reserve increases the discount rate as a part of a contractionary monetary​ policy, there​ is:

Answer 1

Answer:

The correct answer is C)A decrease in the money supply and an increase in the interest rate.

Explanation:

The Discount Rate is the interest rate that the Fed charges to commercial banks for 24-hour or less loans. Commercial banks turn to the FED for these loans when they are in an emergency situation, and are about to lose all reserves, and suffer a bank failure. This is why the Discount Rate tends to be higher than the federal funds rate.

If the FED increases the discount rate in order to apply contractionary monetary policy, the effect will be first a decrease in the money supply because banks will have less incentive to loan, and if they loan less, they create less money (remember than in a fractional reserve banking system banks create money), and thus, the money supply falls.

Secondly, this policy results in a higher interest rate because the less money supply, the less available loans, and the higher the interest rate on those fewer loans.