Question

When a decrease in credit card availability increases the cash people hold, the money-demand curve shifts to the right. As a result, there is an increase in the interest rates. What should the Federal Reserve do to restore the interest rate level back to the original interest rate?

Answer 1

Answer:

The FED must decrease the price of money (or interest rates), and to do that it will buy US securities. By purchasing securities, the FED will decrease the money supply, lower the interest rates and halt inflation. This is called a contractionary monetary policy.

It can also increase the banking system's required reserve ratio, but besides lowering the interest rates, it will also decrease the supply of credit cards even further, so one action could offset the other. That is why this policy might be inefficient in this specific case.