Question

Typically, the Fed targets the fed funds rate. Assume that the Fed is operating the usual way, targeting a specific fed funds value (such as its present target), when the rate of economic growth begins to slow. Outline: (i) the actions the Fed would have to take to sustain its current interest rate target; (ii) the likely impact those actions will have on the rate of economic growth; and (iii) how the yield curve can be expected to change as a result of this event.

Answer 1

1) the fed has two policies that it can use, expansionary monetary policy and contractionary monetary policy. When the economy is slowing down, the demand for liquid money is more than the supply which is because of an increase in the rate of interest.

The fed at this point can stabilize by using it's expansionary monetary policy. Under this the fed buys bonds which leads to an increase in the supply of money in the market. This leads to a decrease in the rate of interest and the fed will be able to maintain it's current target.

2) this policy will impact the economy by increasing the output level of the economy. This will be beneficial for the economy when it is slowing down and will help in making it work normally.

The low interest rate will lead to more investments and thereby the consumption in the economy will increase. The economy will soon return to its initial stage.

3)

The yield curve will now shift down as now the interest rate will be lower than before because of the expansionary monetary policy.