How does monetary policy aim to avoid inflation?


Quick Answer

When the rate of inflation grows beyond 2 percent, the Federal Reserve uses contractionary monetary policy to reduce the money supply, which in turn reduces inflation. The Fed implements contractionary monetary policy by raising the Fed funds rate, raising reserve requirements for banks and through open market operations.

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Full Answer

The Fed funds rate is the interest rate banks must charge each other to borrow money to meet the Fed's reserve requirement. The reserve requirement stipulates that all banks in the United States must have a reserve equal to 10 percent of deposits at the close of each business day. Raising the Fed funds rate forces banks to charge higher interest on loans to consumers and businesses. This makes loans less attractive and reduces the demand for borrowing, which reduces the liquidity in the economy.

With businesses unable to borrow as much, they have to slow expansion plans and hire fewer workers. This results in the economy slowing down as a whole. The resultant reduction in consumer and business demand prevents the cost of goods from rising. The Fed rarely raises the 10 percent reserve requirement because the process is cumbersome for banks. The Fed sometimes fights inflation with open-market operations, in which it sells its U.S. Treasuries to a member bank that places them in reserve, thus reducing the money supply.

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