Social Studies Praxis Practice Test

In a period of inflation, which of the following combinations of monetary policy actions would the Federal Reserve most likely undertake?

1. Decrease the discount rate and buy bonds.

2. Decrease the discount rate and sell bonds.

3. Increase the discount rate and buy bonds.

4. Increase the discount rate and sell bonds.

The correct answer is: Increase the discount rate and sell bonds.

During periods of inflation, the Federal Reserve typically implements monetary policy actions aimed at tightening the money supply to help control rising prices. An effective method for doing this is to increase the discount rate, which discourages banks from borrowing money. When banks face higher costs of borrowing, they are less likely to lend money, which in turn reduces the amount of money circulating in the economy. This decreased money supply tends to dampen consumer spending and investment, addressing inflationary pressures. Additionally, selling bonds in the open market reduces the reserves of banks, as they use their money to purchase these bonds. This action further restricts the availability of cash for lending, reinforcing the tightening of the monetary policy stance. The combination of raising the discount rate and selling bonds effectively contracts the money supply and helps to stabilize price levels during inflationary periods. Therefore, the combination of increasing the discount rate and selling bonds is a proactive approach the Federal Reserve takes to combat inflation.