Question

5. a. Suppose the Fed decides it wants to raise its target interest rate – the fed funds rate – twenty five basis points (.25 percent). How can the Fed accomplish this? Draw a diagram of how this policy action affects the fed funds market.

b. What happens to the money supply (say M1) as a result of this action? Explain.

Diagrams are mandatory

Answer 1

The Federal Funds rate is the rate of interest which the commercial banks need to pay, when they take loans from the Federal Reserve. This further helps them in setting a rate at which retail investors get return or need to pay interest towards loans.

Now, whenever the currency in circulation is on the higher side and the federal reserve desires to reduce the amount of loans that are generated by commercial banks, they increase the Federal Funds rate directly as they govern the same. Another technique of influencing the federal funds rate is via purchase of securities or bonds in the open market using the FOMC which stands for the Federal Open Market Committee purchases bonds from the market which increases their price and reduces the effective interest rates which the market gives.

For example, when the Federal Reserve begins purchasing bonds in the market, the prices of bonds itself goes up meaning that if a 100$ Bond earlier was giving 5$ per month to an investor, the rate of return was 5% per month. However, as the federal reserve buys bonds the price goes up to 110$ per month, which then gives the same return of 5$ but the interest rates or the yield on bonds now would be 4.5% and reduce by 0.5% respectively.

Now, looking over the graph of this the following would be the net effect of an increase on the federal funds market: -

Interest Rates Supply Curve 2.25% 2% Initial Equilibrium Demand Curve Q1 Q Q2 Bank Reserves/Demand for Money

In the above diagram we see that there is an increase of 0.25% in the interest rates. As a result, the demand for money or loan in the economy goes down from Q to Q1 and the supply of bank reserves increases.

It is important to know here that the bank reserves increasing is inversely proportional to the supply of actual currency in the economy which here is known as M1 the currency in the current case study.

As the banking reserves expand, the demand for money goes down and so does the currency in circulation in case of M1. The supply shrinks as now, banks hold more reserves and people see that the interest rates are high and therefore the currency in circulation and the demand for the same declines sharply.

For example, as a retail investor if the interest rate is hiked, you would prefer to save more money and spend less as spending would come at an added cost whereas investment will give a better yield to people.

Please feel free to ask your doubts in the comments section.