Business Degree Certification Practice Test

If the Federal Reserve reduces the money supply, what is the likely effect on private investment and consumer expenditure?

1. An increase in both

2. A decrease in both

3. An increase in private investment

4. A decrease in private investment

The correct answer is: A decrease in both

When the Federal Reserve reduces the money supply, it leads to higher interest rates, as there is less money available for banks to lend. Higher interest rates typically discourage borrowing, both for individuals and businesses. As a result, private investment is likely to decline because businesses may postpone or reduce expenditures on capital projects or expansion plans, finding it more expensive to finance such activities due to increased borrowing costs. Similarly, consumer expenditure is affected because higher interest rates can make borrowing for major purchases, like homes or cars, more expensive. This can lead to a general decrease in consumer spending, as individuals may choose to save more and reduce their debts instead of making significant purchases. Thus, a reduction in the money supply tends to correlate with a decrease in both private investment and consumer expenditure, making this the correct answer.