Chapter 28, Problem 3MCQ

To determine

The relationship between the money supply and the equilibrium interest rate.

Explanation of Solution

The Federal Reserve implements monetary policy primarily by influencing the federal funds rate. The Fed's monetary policy actions, described below, affect the level of the federal funds rate. Changes in the Federal Funds Rate usually lead to changes in other short-term interest rates, ultimately affecting borrowing costs for businesses and consumers, overall money and credit in the economy, employment and inflation.

To contain inflation, the Fed could use monetary policy tools to raise the federal funds rate. In this case, monetary policy should be 'tighter' or 'more contraction' or 'more restrictive'. To mitigate or reverse a recession and boost inflation, the Fed can use monetary policy tools to lower the federal funds rate. In that case, monetary policy should be either 'accommodative' or 'more expansionary' or 'more accommodative'.

To increase the money supply, the Fed buys bonds from banks and injects funds into the banking system.

To reduce the money supply, the Fed sells bonds to banks, removing capital from the banking system.

Therefore, if the money supply decrease then the equilibrium interest rate will increase.

Answer is Option (B)