Future Business Leader Achievments (FBLA) Economics Practice Exam

How does the Federal Reserve System primarily control the money supply?

1. By setting legal reserve requirements, varying the prime rate, and limiting the currency printed.

2. By setting legal reserve requirements, varying the discount rate, and varying the prime rate.

3. By setting quotas on bank loans and selling quotas on government printing of currency.

4. By setting legal reserve requirements, varying the discount rate, and buying/selling bonds.

The correct answer is: By setting legal reserve requirements, varying the discount rate, and buying/selling bonds.

The Federal Reserve System, often referred to as the Fed, has several tools at its disposal to control the money supply, with the buying and selling of bonds being one of the most significant methods. When the Fed buys government securities, it injects liquidity into the banking system, increasing the amount of money available for banks to lend. This action can lower interest rates and stimulate economic growth. Conversely, when the Fed sells bonds, it removes liquidity from the system, which can raise interest rates and help control inflation. Setting legal reserve requirements is another critical mechanism, as this determines the amount of money banks must hold in reserve and not lend out. By altering these requirements, the Fed can influence how much money banks can create through lending. Varying the discount rate also plays a role. The discount rate is the interest rate charged to commercial banks for short-term loans from the Fed. Changes in this rate can influence how much banks borrow and subsequently what they lend out to consumers and businesses. In summary, the correct choice emphasizes the Fed's use of these three tools—legal reserve requirements, the discount rate, and the buying and selling of bonds—providing a comprehensive approach to managing the money supply effectively.