If the Federal Reserve increases the discount rate:
A the federal funds rate must decrease.
B the money supply is not likely to change.
C the money supply is likely to increase.
D the money supply is likely to decrease.
The correct answer and explanation is:
The correct answer is D: the money supply is likely to decrease.
When the Federal Reserve increases the discount rate, it becomes more expensive for banks to borrow money from the Federal Reserve. The discount rate is the interest rate at which commercial banks can borrow short-term funds from the central bank. An increase in this rate typically leads to higher borrowing costs for banks. As a result, banks are less inclined to borrow from the Federal Reserve, and they may also be less willing to lend money to businesses and consumers.
This reduced borrowing and lending activity results in a decrease in the overall money supply in the economy. The money supply is largely influenced by how much lending and borrowing occurs in the financial system, so when banks borrow less, they have fewer reserves to lend to customers, leading to a contraction in available credit. Fewer loans mean there is less money circulating in the economy, which can lead to lower consumer spending and investment.
The Federal Reserve uses the discount rate as a tool to influence the money supply and manage inflation or stimulate economic growth. By increasing the discount rate, the Fed is typically trying to curb inflation by reducing the amount of money in circulation. This can help control inflationary pressures by slowing down the rate at which money is flowing through the economy.
Overall, an increase in the discount rate tends to make borrowing more expensive, which discourages borrowing and lending, ultimately leading to a reduction in the money supply.