Question

Why does the Federal Bank increase the supply of reserves when output rises if it is targeting the federal fund rate? What would happen to the federal fund rate if output rose and the Federal Bank held the supply of reserves fixed?

Answer 1

Let us first understand what is Federal Funds rate ,  it is the interest rate at which depository institutions (such as banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis . Targetting a federal funds rate means fixing a certain rate . If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits . So increasing the supply of reserves is an expansionary monetary policy which increases money supply . So when output rises , increasing money supply would cause excess amount of supply of loanable funds causing the federal funds rate to balance or remain at target .

If output rose , demand for funds and money rises to buy or produce those output . Now if reserves are fixed then interest rate rises in the economy . So federal funds rate or lending among banks interest rate also rises .