Contractionary Monetary Policy

When the Federal Reserve uses its tools to put the brakes on the economy in order to prevent inflation. The will typically mean raising the federal funds rate, which in turn, increases the rate that banks will charge each other to borrow funds in order to meet the requirement of the Federal Reserve. This refers to the amount that the Fed requires banks to have on deposit each night when they close their books. Without having this requirement, banks would loan out each and every dollar that they have. Thus, raising the federal funds rate will decrease the money supply because it is essentially better for the banks to lend a little bit less and not have to pay a higher federal funds rate.

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