Final answer:
The best response of the Federal Reserve is to adopt a contractionary monetary policy, which involves increasing interest rates and reducing the money supply to control inflationary pressures. This can be achieved through selling government securities and increasing the reserve requirement for banks.
Step-by-step explanation:
The best response of the Federal Reserve when the equilibrium level of output is above full employment and the economy is at the risk of inflation is to adopt contractionary monetary policy. This involves increasing interest rates and reducing the money supply in order to reduce aggregate demand and curb inflationary pressures. By doing so, the Federal Reserve aims to prevent the economy from overheating and maintain price stability.
One way the Federal Reserve can implement contractionary monetary policy is by selling government securities in the open market, which reduces the amount of money available in the economy. This decreases the ability of businesses and households to borrow and spend, thus reducing aggregate demand.
Another tool the Federal Reserve can use is increasing the reserve requirement for banks. By requiring banks to hold a higher percentage of their deposits as reserves, less money is available for lending, which again decreases aggregate demand. These actions collectively work to bring the economy back to its full employment level without causing excessive inflation.