Bachelor of General Studies (BGS) Degree Practice Exam

How does the Federal Reserve influence the economy?

1. By issuing new currency

2. By raising and lowering interest rates

3. By controlling tax rates

4. None of the above

The correct answer is: By raising and lowering interest rates

The Federal Reserve influences the economy primarily through the manipulation of interest rates. By raising or lowering the federal funds rate, which is the interest rate at which banks lend to each other overnight, the Federal Reserve can affect the overall cost of borrowing money. When the Federal Reserve lowers interest rates, it generally encourages borrowing and spending by businesses and consumers, which can stimulate economic growth. Conversely, when it raises interest rates, borrowing becomes more expensive, which can help to cool off inflation and prevent an overheated economy. This mechanism of adjusting interest rates is a critical tool of monetary policy. The Fed's actions directly impact other interest rates in the economy, including those for mortgages, loans, and savings, thereby influencing consumption, investment, and overall economic activity. The other choices either misinterpret the role of the Federal Reserve or refer to functions outside its direct jurisdiction. While it can issue new currency, this is not its primary method of economic influence. Similarly, adjusting tax rates falls within the purview of Congress and the executive branch, not the Federal Reserve. Therefore, the correct choice accurately reflects the key role that interest rate adjustments play in the Federal Reserve's strategy to manage the economy.