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

(iii) how the yield curve can be expected to change as a result of this event.

Answer 1

The Federal Reserve is the Central Bank of the United States which governs the commercial banks and regulates the flow of money in the economy. It does so by maintaining an interest rate or making changes to the same if and when required.

1) During a recession, the flow of money in the economy is low. This means that the country does not have sufficient funds and this needs to be provided by the Federal Reserve so as to maintain the flow of money in the economy and the interest rates as well.

To do so, the Federal Reserve increases the supply in the market by purchasing bonds from the market place. When the purchase of bonds is done, in exchange the Federal Reserve supplies money to banks or other institutions which hold them and the resultant is that the interest rates can be lowered or maintained as now the banks or financial institutions have sufficient availability of capital with them. Generally, for the banking sector, if the availability of money in the economy is higher, it is easier to lower or to maintain the same interest rates. The Federal Bank thus, by pumping money into the country through purchase of bonds ensures that the interest rates in the country remain stable.

2) As the Federal Reserve increases the availability of funds in the markets, it becomes easier for banks to be able to grant loans at the same or cheaper rates. As this happens, people increase their demand for goods and services, and producers find this increasing demand a clear reason for themselves to be able to expand operations at a lower cost as loan rates are stable or lowered down. As a result of these actions, the producers and consumers begin expanding and the economy returns back to its normal position of high growth rates. This action has been used in all major recessions such as that of 2008 and the recent Covid Pandemic and helps in reviving the economy post which the additional money supplied by the Federal Reserve can be withdrawn if required.

3) The core intent of the Federal Reserve during a time of recession is to prohibit people from saving money in the form of bonds or long-term investments. What the organization wants is for people to spend more money in the economy and thus enable themselves to control the supply of money in a positive manner.

As a result of additional supply of money in the economy as a result of the sale of bonds by the Federal Reserve, the yield or the benefit which consumers would get from purchasing the bonds goes down as the prices go up. This results in the overall yield curve being negative or flat wherein the people who invest money get significantly lesser returns on their investment. As this happens, they are encouraged to spend more money in the country or to expand business from the view point of a producer which helps in making the necessary adjustments to the economy.

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