Monetary policy regulates the money supply thus it is used to combat inflation which is increased rate of price levels brought by money oversupply in the economy (Jensen et al 5). By employing bank reserve ratio, discount rate and open market operations, money supply and inflation is limited. Reserve ratio is the percentage of total deposits kept in reserve with the federal bank. An increase in reserve ratio is advisable as it will reduce the commercial bank reserves as more money is used to maintain the reserve ratio (Jensen et al 1). This reduces the amount of money available to give out as loans and other credit facilities hence increases interest rates as the cost of borrowing rises. Aggregate demand falls as money in the consumers’ pocket is reduced due to drying up lines of credit. As a result inflation is limited as prices are pressurized to fall.
Discount rate is the rate charged as interest by the federal bank on borrowing by banks to cover a shortfall in their reserve ratio occasioned by unexpected transactions (Jensen et al 4). Hence I would advise the Federal bank to increase the discount rate forcing banks to increase their reserves to avoid borrowing which would be expensive (Jensen et al 8). Money supply in the economy will shrink as banks restrict loans thus increasing interest rates. Aggregate demand diminishes as consumers’ pockets become tight due to money squeeze in the economy. Inflation would be on a downward trend as prices decrease due to low consumption.
Participation in the market by selling bonds is another avenue I would advocate as a means of controlling the inflation by mopping up excess money supply. Investing in bonds draw money from circulation and diminishes commercial banks’ reserves as banks invest in bonds. Alternative investments are ‘crowded out’ contributing to rise in interest rates as the high yielding bonds compete with the rest of the market for investment money. Aggregate demand declines as the market defers consumption to invest in the bonds pushes down inflation (Jensen et al 58).