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The Federal Reserve

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Economics

Do you notice when gasoline prices go up and up and up? When that happens, who will stop them from going to astronomical levels? What's the force that drives housing prices? Which institution intervenes whenever the economy goes into recession?

All these questions can be addressed once you learn about the Federal Reserve System, and this article will teach you everything you need to know about it.

The Federal Reserve Definition

Often referred to as "the Fed," the Federal Reserve System (FRS) is the central bank of the United States and perhaps the most powerful financial organization globally. It was established to give the nation a monetary and financial system that was secure, adaptable, and stable.

The Fedral Reserve.Flag of the United State Fedral Reserve. StudySmarterFlag of the United States Federal Reserve Bank, Wikimedia Commons, https://commons.wikimedia.org/wiki/File:Flag_of_the_United_States_Federal_Reserve_Bank.svg

To understand what the Federal Reserve System does you would have to understand the role of a central bank in an economy. First, it is not like other types of banks that serve consumers and businesses. Instead, the central bank serves as the banking institution for these other types of banks.

A central bank serves as the financial institution with exclusive power over the circulation of money in a country or set of countries. It is responsible for ensuring that the money flowing within the economy is stable. Additionally, it regulates other financial institutions in order to bring stability or help maintain stability in the financial environment.

Before the Federal Reserves System was created, the United States was the only major financial power that did not have a central bank. Throughout the 19th century and the beginning of the 20th century, the United States economy was plagued by recurrent financial panics. This resulted in significant economic disruptions due to a large number of banks and businesses failing in a very short period of time and spurred the U.S. government to create a central bank in 1913.

The Federal Reserve System is the central bank of the United States that ensures stability in the banking system and regulates the money supply in the U.S. economy.

The Federal Reserve System has extensive authority to intervene in the financial system to maintain stability, and it is the central regulator of banks that are members of the system. It serves as a lender of last resort for member institutions that have exhausted all other options for borrowing money from other sources.

System of the Federal Reserve

The Federal Reserve System is comprised of twelve regional Federal Reserve Banks, each of which is responsible for a particular geographic region of the United States. Each of them has a president, and they supervise the region to which they belong. They are located in Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, San Francisco, San Jose, and the headquarters in Boston.

Additionally, the Federal Reserve System consists of the Board of Governors whose function is to supervise and regulate the twelve Federal Reserve Banks. The Board of Governors is located in Washington D.C. It has seven members, each appointed by the President and approved by the Senate. They serve for a term of fourteen years to remove any exposure to the ruling party's politics.

In terms of its legal structure, the Federal Reserve is not part of the U.S. government, nor is it owned by private institutions; instead, it governed by the Board of Governors that oversee the twelve Federal Reserve Banks.

The Federal Reserve Act

After a particularly bad panic of 1907 that caused a run on the banks and significant losses to business and personal wealth, Congress enacted the Federal Reserve Act. This act established the central bank and the Federal Reserve System. It was signed into law by President Woodrow Wilson on December 23, 1913.

The Federal Reserve Act established the twelve regional Federal Reserve Banks as the system that is responsible for managing the country's money supply, overseeing banks, and acting as a lender of last resort. Additionally, the Federal Reserve Board of Governors, whose members are selected by the president, was formed to provide leadership for the Federal Reserve System.

After another series of bank runs between 1930 and 1933, several additional laws regarding the banking system were enacted in 1933. The 1933 Banking Act was an amendment to the Federal Reserve Act. It established the Federal Reserve's Open-Market Committee, responsible for overseeing the Federal Reserve's activities in the financial markets.

Functions of the Federal Reserve

Functions of the Federal Reserve include: creating monetary policy, providing financial services, regulating and supervising the banking system, maintain a stable financial system.

Monetary policy

Perhaps this is one of the most critical functions of the Federal Reserve. The Fed uses different tools in the monetary policy process to address macroeconomic issues. When there are major macroeconomic shocks in the economy that affect the GDP of the United States or cause inflation, the Fed is in charge of managing these problems.

When COVID-19 hit the U.S. economy in early 2020, the Fed used monetary policy to lower interest rates, in order to aid businesses and individuals affected by the economic disruption from COVID-19.

Providing financial services

Another main function of the Fed is to provide financial services to other financial institutions and the U.S. government. Commercial banks and other types of major financial institutions use the Federal Reserve Banks to store their money, process checks, receive cash, as well as transfer funds.

Additionally, the United States government uses the Federal Reserve for financial services. The United States Treasury maintains a checking account with the Federal Reserve, which means that when the federal government issues a check, the check is made on a Fed account.

Regulate and supervise banking institutions

Regulating and supervising banking institutions is another essential function of the Federal Reserve System. The Fed makes sure that commercial banks adhere to existing financial rules and regulations. This is important to reduce the risks faced by commercial banks. When commercial banks engage in too much risk, the Federal Reserve steps in. The Fed is responsible for overseeing commercial banks.

Maintain a stable financial system

A sound and stable financial system enable the economy to prevent recessions such as the 2008 financial crisis. The Federal Reserve’s function is to ensure that all the financial institutions in the economy and the financial system as a whole are efficient and stable. When financial institutions are at risk of collapsing, the Fed helps them out by providing liquidity and mitigating the spillover effects a financial institution’s bankruptcy would have on the economy.

Monetary Policy tools used by the Federal Reserve

There are three main tools that the Fed uses to ensure a stable economy and stable prices. Those three tools include: reserve requirements, the discount rate, and open-market operations.

Reserve requirement

The reserve requirement is a ratio set by the Federal Reserve, which requires commercial banks to keep a specific portion of their checkable deposits in their reserves. If the reserve requirement ratio was 10%, whenever someone deposits $1000 at a commercial bank, the bank must keep $100 in their reserves.

In this way, the Fed requires a portion of each bank's deposits to be kept in reserve and not used to make loans. This requirement is in case there is a withdrawal request by clients who want to remove their funds from the bank. The bank must have the funds available to provide to their clients; otherwise, it would cause panic in the market.

When the banks don’t have the necessary reserves, these individual banks borrow money in the federal funds market in order to meet the reserve requirement and avoid repercussions. The federal funds market is an inter-bank financial market that allows banks to borrow money overnight.

The federal funds rate is the interest rate at which banks can borrow from each other--usually just overnight--in order to meet their reserve requirements. It is set by supply and demand in the federal funds market.

Discount rate

The discount rate refers to the rate at which banks that need reserves can borrow from the Fed itself. The discount rate is set above the federal funds rate so that banks borrow from the Fed only when the federal funds market is maxed out.

The discount rate is the interest rate at which banks can borrow from the Fed. The Fed sets the discount rate.

The discount rate is expressed in terms of percentage points above the federal funds rate. Typically set at 1%, the discount rate was lowered to .25% during the financial crisis in the U.S. in the spring of 2008.

The discount rate is used by the Fed as a tool to control the money supply in the economy, and ultimately the overall consumption and investment. When the discount rate is lower, banks can more cheaply borrow money from the Fed. This enables banks to lend more money out to potential borrowers, which injects more money into the economy. The additional borrowing allows consumers to increase their consumption and allows businesses to increase investments.

On the other hand, if the Fed decides to increase the discount rate, then banks have to pay a higher interest rate for every dollar they borrow, which means those banks have fewer dollars available to lend to their own potential borrowers. Thus, the money supply will fall, as banks will be discouraged from lending money. Ultimately, the Fed expects this will decrease overall consumption and investment.

When the Fed raises or lowers interest rates, it is the discount rate that is changing. This is actually the interest rate that applies only to banks and only when borrowing from the Fed, but it then ripples out into the economy as those banks adjust the interest rates they charge their borrowers, and hopefully also the interest rates they offer on their clients' deposits.

Open-market operations

The Federal Reserve's Open-Market Committee (FOMC) is the entity that conducts these open-market operations. Open-market operations refer to the buying and selling of U.S. government debts by the Fed.

The FOMC buys government securities, and treasury bills, but not directly from the U.S. government. Instead, the FOMC buys these assets from other financial institutions. The reason for that is to prevent the Fed from financing government debt just by printing more money.

When the Fed buys treasury bills, the Fed takes dollars out of the national reserves to purchase the treasury bills, and those dollars represent an increase in the amount of money circulating in the economy. On the other hand, when the

Fed sells treasury bills, in these public markets, the Fed is taking money out of the economy and returning it to the national reserves. As a consequence, the money circulating in the economy shrinks.


The FOMC operates by first determining the federal funds rate that it thinks would be beneficial for the economy. The federal funds rate is set by supply and demand in the federal funds market, but the FOMC then buys and sells treasuries in an effort to steer the economy toward the target federal funds rate.

Importance of the Federal Reserve

Through the performance of all of its various responsibilities and functions, such as setting interest rates, regulating financial institutions, and controlling the money supply, the Federal Reserve contributes significantly to the preservation of the economy's health, particularly during times of economic crisis.

A key important role of the Federal Reserve System is to control the money supply, which affects consumption and investment, and ultimately maintains price stability in the market. Other key roles include making sure that the dollar maintains its value and that the economy doesn't slip into an irreversible crisis.

Imagine if you woke up in the morning and saw that aggregate prices doubled last night whilst you were sleeping! It's unthinkable, right? Well, many developing countries experience such high inflation levels. These cases demonstrate the importance of a central banking system like the Federal Reserve.

Even during times of economic expansion, the actions taken by the Federal Reserve, and the measures taken in response to those activities, can have a genuine and significant influence on your day-to-day life. Changes in interest rates have direct consequences, such as higher or lower consumer interest rates. Other consequences, such as swings in stock values, are indirect. Changes in interest rates can affect the value of other assets like your pension fund, savings fund, housing prices, basically all aspects of your life.

The Federal Reserve - Key Takeaways

  • The Federal Reserve System is the central bank of the United States that ensures stability in the banking system and regulates the money supply in the U.S. economy.
  • The Federal Reserve System is comprised of twelve regional Federal Reserve Banks, each of which is responsible for a particular geographic region of the United States.
  • The Federal Reserve System was established by the Federal Reserve Act in 1913, in reaction to the financial crisis of 1907, and it was significantly expanded in 1933, in reaction to financial crises between 1930 and 1933.
  • Functions of the Federal Reserve include: monetary policy, providing financial services, regulating and supervising other types of banks, and maintaining a stable financial market system and overall economy.
  • There are three main tools the Fed uses to ensure a stable economy. These three tools are: (1) the reserve requirement, (2) the discount rate, and (3) open-market operations.
  • A key role of the Federal Reserve System is to change interest rates in order to control the money supply, which influences consumption and investment and maintains price stability in the market.

The Federal Reserve

The Federal Reserve System is the central bank of the United States that ensures stability in the banking system and regulates the money supply in the U.S. economy.

Creating monetary policy, providing financial services, regulating and supervising banks, and maintaining stability in the financial system.

The Federal Reserve System is comprised of twelve regional Federal Reserve Banks, each of which is responsible for a particular geographic region of the United States. Each of them has a president, and they supervise the region to which they belong.

Additionally, the Federal Reserve System consists of the Board of Governors whose function is to supervise and regulate the twelve Federal Reserve Banks.

A key important role of the Federal Reserve System is to control the money supply, which affects consumption and investment, and ultimately maintains price stability in the market. Other key roles include making sure that the dollar maintains its value and that the economy doesn't slip into an irreversible crisis. 

There are three main tools that the Fed uses to ensure a stable economy and stable prices. Those three tools include: reserve requirements, the discount rate, and open-market operations.

Final The Federal Reserve Quiz

Question

What is the Federal Reserve System?

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Answer

The Federal Reserve System is the central bank of the United States that ensures stability in the banking system and regulates the money supply in the U.S economy.

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Question

Why was the Federal Reserve System established?

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Answer

The Federal Reserve System was established in response to the financial crisis in the early 20th century in the US to give the nation a monetary and financial system that was secure, adaptable, and stable.

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Question

What's the role of the central bank in the economy?

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Answer

A country's central bank is a financial institution that has exclusive power over the circulation of money in the country. In the U.S., the role includes creating monetary policy, providing financial services, regulating and supervising banks, and maintaining stability in the financial system.

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In which year was the Federal Reserve System established?

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In 1913.

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How many regional banks are there?

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The Federal Reserve System is comprised of 12 regional Federal Reserve Banks, each of which is responsible for a particular geographic region of the United States. Each of them has a president, and they supervise the region they belong to.

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Question

How many members are in the board of Governors of the Fed?

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The Federal Reserve System consists of the Board of Governors whose function is to supervise and regulate the 12 Federal Reserve Banks.

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What's the Federal Reserve Act?

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The Federal Reserve was founded by the Federal Reserve Act, which was signed by President Woodrow Wilson on December 23, 1913, in reaction to the financial crisis of 1907. 

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What are the main functions of the Federal Reserve System?

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Creating monetary policy, providing financial services, regulating and supervising banks, and maintaining stability in the financial system

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Question

Explain monetary policy as a function of the Federal Reserve System?

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Perhaps this is one of the most critical functions of the Federal Reserves. FEDs use different tools in the monetary policy process to address macroeconomic issues. When there are major macroeconomic shocks in the economy that affect the GDP of the United States, the Fed is in charge of managing these problems.

Show question

Question

Explain providing financial services as a function of the Federal Reserve System?

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Answer

Another main function of the financial reserves is to provide financial services to other financial organizations as well as the U.S government. Commercial banks and other types of major financial institutions use the Federal Reserve Banks to store their money, process checks, receive cash, as well as transfer funds. 

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Explain regulation and supervision of the banking industry as a function of the Federal Reserve System.

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Regulating and supervising banking institutions is another essential function of the Federal Reserve System. The Fed make sure that commercial banks adhere to the financial rules and regulations in place. This is important to reduce the risk that commercial banks are exposed to. When commercial banks engage in too much risk, the Federal Reserve steps in and stops the bank from causing turmoil in the market.

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Question

Explain maintaining financial stability as a function of the Federal Reserve System.

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Answer

A sound and stable financial system enable the economy to prevent recessions such as the 2008 Financial Crisis. The Federal Reserve’s function is to ensure that all the financial institutions in the economy and the financial system as a whole are efficient and stable. When financial institutions are at risk of collapsing, the Fed helps them out by providing liquidity and mitigating the spillover effects a financial institution’s bankruptcy would have on the economy.

Show question

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What are the main monetary tools used by the Fed?

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There are three main tools the Fed use to ensure a stable economy. Those three tools include: reserve requirement, discount rate, and open market operations.

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Question

Explain reserve requirement.

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The reserve requirement is a ratio set by the Federal Reserve, which requires commercial banks to keep a specific portion of their checkable deposits in their reserves. If the reserve requirement ratio was 10%, whenever someone deposits $1000 at a commercial bank, the bank must keep $100 in their reserves. The Fed requires a portion of deposits to be kept in reserves in case there is a withdrawal request by clients to remove their funds from the bank. The bank has to have the funds asked by their clients; otherwise, it would cause panic in the market.

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Why are bank required to keep a portion of their deposits in reserves?

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In case there is an immediate withdrawal demand from clients.

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What is the discount rate?

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The discount rate refers to the rate at which banks that need reserves can borrow from the the Fed. The discount rate is set above the rate at federal funds market (federal funds rate) to discourage banks from running all the time into the Fed for money.

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How the Fed uses discount rate to control the money supply?

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The spread between the discount rate and the federal funds rate is used as a tool to control the money supply in the economy. When the spread between the federal funds rate and the discount rate is smaller, then it becomes cheaper for banks to borrow money from the Fed. This enables them to loan more money, which results in more money injected in the economy.

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What are open market operations?

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Open market operations refer to the buying and selling of U.S government debts by the Fed. The government securities, Treasury bills, are not bought directly from the U.S government instead bought via other financial institutions. The reason for that is to prevent the Fed from financing government debt just by printing more money.

When the Fed buys Treasury bills, the money circulating in the economy increases. On the other hand, when the Fed sells Treasure bills, the money circulating in the economy shrinks.

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What's a key importance of the Federal Reserve System?

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A key important role of the Federal Reserve System is to control the money supply so that price stability is maintained in the market.

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What is inflation targeting?

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Inflation targeting is the term for the government setting the desired inflation rate and using fiscal and monetary policy to achieve it.

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What is an example of inflation targeting?

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An example of inflation targeting would be the Fed's increase in the interest rate to keep inflation at a desirable rate. 

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Why are inflation targeting policies used?


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Inflation targeting policies are used to maintain economic stability and avoid triggering market crashes and recessions.

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What are the benefits of using inflation targeting?

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A benefit of inflation targeting is that the government has a better chance of preventing severe recessions.

Another benefit is that inflation targeting helps reduce uncertainty in the markets. 

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What are constraints with inflation targeting?


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Limiting inflation is made difficult by the natural tendency of prices and wages to be sticky.

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What is inflation?

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Inflation is defined as the rise in the general level of prices. 

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What happens when an economy experiences high inflation levels?

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When inflation is higher than expected, it indicates a widespread decrease in real income or the ability of one's income to purchase things. 

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Explain how high inflation leads to lower economic growth.

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When inflation is higher than expected, it indicates a widespread decrease in real income or the ability of one's income to purchase things. When consumers and businesses struggle to maintain their everyday purchases, they may reduce spending. This triggers a recession, a decline in national output (real gross domestic product, or real GDP), and can lead to rising unemployment as businesses, no longer receiving their usual revenue, must lay off workers

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Which institution is responsible for inflation targeting policies?

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Typically, inflation targeting is more of a monetary policy relating to money supply and is conducted by a nation's central bank. The United States central bank, the Federal Reserve System, adjusts the money supply to try and maintain an inflation rate target. 

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What is a primary use of inflation targeting policies?

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A primary policy use of inflation targeting is to avoid the triggering of a recession.

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What is the long term inflation rate target in the US?

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 The long-term inflation rate target is roughly 2 percent, meaning that the price level will increase about two percentage points annually. 

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Explain how reducing uncertainty in the market through inflation targeting benefits the economy.

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When investors are well aware of inflation expectations, they can better plan their portfolios and have the incentive to invest. If investors weren't clear about where inflation was heading, and there was uncertainty in the markets, they would be less willing to invest their money. This, in turn, would lower investment spending, and economic output would fall.

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What would happen if there wasn't an inflation target?

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Without an inflation target, policymakers would easily ignore inflation until it had become excessive and difficult to control. The inflation target forces accountability, and also reassures the public, and helps maintain consumer and investor confidence. 

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Explain how sticky prices provide a challenge for inflation targeting.

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Sellers naturally resist lowering prices, even during recessions. However, during a booming economy, sellers will likely increase prices as much as possible until they risk reduced sales. Therefore, while the government may actively be trying to reduce inflation, sellers across the market will likely resist lowering their prices, “locking in” inflation.

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Explain how future expectations about price levels provide a challenge for inflation targeting.

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When consumers and businesses anticipate excessive demand, they often increase their spending to buy goods and services before prices rise further. This is the demand determinant known as the expectation of future prices. Demand actually increases today when buyers assume that prices will increase in the future.

Consumers and businesses can complicate government efforts to set an inflation target by not buying when the government wants. When inflation is rising, consumption may increase to try to “buy while it’s still cheap.”  When inflation begins to fall at first, consumption may pick up again in anticipation of falling prices, driving inflation back up.  

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