A problem that the Federal Reserve (Fed) faces when it attempts to control the money supply is that:

• A. the Fed cannot influence interest rates through open market operations
• B. the Fed cannot control the amount of money that households choose to hold as cash rather than deposits
• C. the Fed is unable to set the federal funds rate
• D. the Fed is required to balance the federal budget before changing the money supply

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the role of the Federal Reserve (Fed) in controlling the money supply. The Fed primarily uses open market operations, such as buying and selling government securities, to influence the amount of reserves in the banking system, which in turn affects the money supply.
2. Step 2: Recognize that while the Fed can control the monetary base (reserves plus currency in circulation), it cannot directly control how much money the public decides to hold as cash versus deposits in banks. This behavior affects the overall money supply through the money multiplier effect.
3. Step 3: Recall that the money supply (M) is related to the monetary base (B) and the money multiplier (m) by the formula: \(M = m \times B\), where the money multiplier depends on the public's preference for holding cash relative to deposits and banks' reserve ratios.
4. Step 4: Note that if households decide to hold more cash instead of deposits, the money multiplier decreases, which reduces the effectiveness of the Fed's control over the money supply, even if the Fed changes the monetary base.
5. Step 5: Conclude that the key problem the Fed faces is its inability to control the public's cash-holding preferences, which limits how precisely it can control the total money supply through its policy tools.