In the context of a severe recession, which monetary policy action should the Federal Reserve take to stimulate aggregate demand?

• A. Lower the federal funds rate
• B. Sell government securities in the open market
• C. Increase the reserve requirement
• D. Raise the discount rate

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the goal of monetary policy during a severe recession, which is to stimulate aggregate demand to boost economic activity.
2. Step 2: Recall that lowering the federal funds rate reduces the cost of borrowing, encouraging businesses and consumers to take loans and spend more, thus increasing aggregate demand.
3. Step 3: Recognize that selling government securities in the open market is a contractionary policy because it reduces the money supply, which would decrease aggregate demand, so this is not appropriate during a recession.
4. Step 4: Understand that increasing the reserve requirement means banks must hold more reserves and can lend less, which reduces the money supply and aggregate demand, so this action is also contractionary.
5. Step 5: Know that raising the discount rate makes borrowing from the Federal Reserve more expensive for banks, leading to less lending and lower aggregate demand, which is not suitable during a recession.