Question

An economy is in short run equilibrium. The demand for private consumption increased and as a result there is an increase in the national product. Mainting the monetary policy according to the Taylor rule implies an increase in the interest rate and the central bank informed the proper increase. After a while it was found that the interest rate remained unchanged. What can the central bank do in order to change the interest rate as planned?

Answer 1

The Taylor Rule suggests that the Federal Reserve should raise rates when inflation is above target or when gross domestic product (GDP) growth is too high and above potential. It also suggests that the Fed should lower rates when inflation is below the target level or when GDP growth is too slow and below potential.

The Central Bank usually increase interest rates when inflation is predicted to rise above their inflation target. Higher interest rates tend to moderate economic growth. Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending. Higher interest rates tend to reduce inflationary pressures and cause an appreciation in the exchange rate.

The implementation of monetary policy – e.g., how exactly a central bank raises interest rates – differs across countries and even over time within countries.

the Fed primarily implemented monetary policy by setting a target for the federal funds rate, which is an interest rate paid when banks borrow overnight from other banks. The Fed used “open market operations” to pursue that target; that is, by selling (purchasing) securities, the Fed reduced (increased) the supply of bank reserves, thus leading to a higher (lower) federal funds rate. However, in the aftermath of the financial crisis and the Fed’s large-scale asset-purchase programs, the banking system has a large amount of excess reserves, meaning that the traditional approach to raising interest rates will no longer work. Rather the Fed intends to affect the federal funds rate by changing the interest paid on excess reserves or by conducting overnight reverse repurchase agreements. Both policies entail the Fed paying interest to financial institutions in order to pull the federal funds rate and other short-term market interest rates into the target range via arbitrage.