Question

Shelley is the Chairman of the Federal Reserve. She is in charge of making decisions for the Fed that will impact the economy in the country, and she must make her decisions from current market data. An economy that is growing too fast could be detrimental as it could lead to high inflation and devaluing of the currency, but an economy that is sluggish will cause unemployment to rise. Shelley is faced with a current unemployment rate of 4.7%. This rate, coupled with an inflation rate over the last year of 496, causes Shelley to take action. The Fed is currently offering a discount rate of 1.8%, and the market interest rate on one-year investments is averaging 2.3%. After meeting with the president, Shelley learns that the administration does not want to raise taxes, as it fears this could hurt its public image in the year prior to elections. The president has been making frequent public statements that the economy has been doing very well the past couple years and the dollar has been strong. As the president is shying away from using fiscal policy to control the economy, it is now up to you to use monetary policy.
From the scenario the chairman of the fed should:

a. increase the reserve requirement

b decrease the reserve requirement

c.. let the president/congress decrease taxes

Answer 1

Answer: a. increase the reserve requirement

Explanation:

With such an inflation rate, the economy is probably producing at a point higher than its potential GDP which means that it is overheated. It therefore needs to be controlled and brought back down to its potential level.

Restrictive monetary policy - reducing money supply - would be a way to do this. The Fed can do this via a variety of ways but one way is by raising the reserve requirement. This would require banks to leave more deposits with the Fed. As these cannot then be lent to the public, money supply will decrease.