When inflation is rising above the Federal Reserve’s target, which monetary policy action is most consistent with the Fed’s goal of slowing the economy to reduce inflation?

• A. Increase the money supply rapidly to boost aggregate demand
• B. Lower the federal funds rate target (ease monetary policy) to increase borrowing and spending
• C. Raise the federal funds rate target (tighten monetary policy) to reduce borrowing and spending
• D. Cut reserve requirements to encourage banks to lend more

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the Federal Reserve's dual mandate, which includes promoting maximum employment and stable prices, with a typical inflation target around 2%. When inflation rises above this target, the Fed aims to slow down the economy to reduce inflationary pressures.
2. Step 2: Recognize that to slow the economy, the Fed uses contractionary (tight) monetary policy, which involves actions that reduce aggregate demand by making borrowing more expensive and saving more attractive.
3. Step 3: Identify the key tool for implementing tight monetary policy: raising the federal funds rate target. This increases the cost of borrowing for banks, which then pass on higher interest rates to consumers and businesses, leading to reduced spending and investment.
4. Step 4: Contrast this with other options: increasing the money supply or lowering the federal funds rate would stimulate the economy and increase inflation, which is the opposite of the Fed's goal in this scenario. Cutting reserve requirements also encourages more lending, which would not reduce inflation.
5. Step 5: Conclude that raising the federal funds rate target is the most consistent monetary policy action to slow the economy and reduce inflation when inflation is above the Fed's target.