The Federal Reserve can close an inflationary gap through the use of its three main tools of monetary policy: open market operations, the discount rate, and reserve requirements.
1. Open Market Operations
By selling government securities in the open market, the Federal Reserve can reduce the amount of money that banks have available to lend. When banks have less money to lend, interest rates tend to rise, which discourages borrowing by consumers and businesses. This decrease in spending can help lower demand in the economy, thus closing the inflationary gap.
2. Discount Rate
The discount rate is the interest rate at which commercial banks can borrow from the Federal Reserve. If the Federal Reserve increases the discount rate, it becomes more expensive for banks to borrow money. Consequently, banks may pass these higher costs onto consumers in the form of higher interest rates on loans. This can slow down borrowing and spending, further helping to close the inflationary gap.
3. Reserve Requirements
Reserve requirements dictate the amount of funds that banks must hold in reserve against their deposits. By increasing reserve requirements, the Federal Reserve can limit the amount of money that banks can lend out. This has a direct effect on the money supply and raises interest rates, which can reduce consumer and business spending. Lower demand helps align the economy with the sustainable output level, thereby closing the inflationary gap.
In summary, the Federal Reserve uses these tools to control the money supply and influence interest rates, ultimately aiming to reduce demand and curtail inflation when facing an inflationary gap.