Question

The following statements come from a Federal Reserve press release dated June 14, 2017:

The Board of Governors of the Federal Reserve System voted unanimously to raise the interest rate paid on required and excess reserve balances to 1.25%, effective June 15, 2017.

The Board of Governors of the Federal Reserve System voted unanimously to approve a 1/4 percentage point increase in the primary credit rate to 1.75%, effective June 15, 2017.

With the above information in mind, answer and complete the following:

What is the effect of the Fed’s action on interest rates in the short-run? What is the effect on the aggregate price level and aggregate output in the short-run?

Demonstrate your answer with a graph of the loanable funds market and AD/AS analysis.

Answer 1

solution-

The Federal Open Market Committee  is the Fed's operations manager. This committee meets eight times a year. The members vote to change the fed funds rate when the central bank wants banks to lend either more or less. The Fed's Board of Governors usually changes the discount rate to remained aligned with the fed funds rate.

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the combination of consumer spending, investments, government spending, and net exports within a given economic system (often written out as AD = C + I + G + nX). As a result of this, increases in overall capital within an economy impacts the aggregate spending and/or investment. This creates a relationship between monetary policy and aggregate demand.

This brings us to the aggregate demand curve. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is also referred to as the effective demand.

The aggregate demand curve illustrates the relationship between two factors – the quantity of output that is demanded and the aggregated price level. Another way of defining aggregate demand is as the sum of consumer spending, government spending, investment, and net exports. The aggregate demand curve assumes that money supply is fixed. Altering the money supply impacts where the aggregate demand curve is plotted.

For example, a higher discount rate means it's more expensive for them to borrow funds, and so they have less cash to lend out. Even if they don't borrow at the Fed discount window, they find that all the other banks have raised their lending rates as well. The Fed raises the discount rate when it wants all interest rates to rise. That's called contractionary monetary policy, and central banks use it to fight inflation. This reduces the money supply, slows lending, and therefore slows economic growth.

The opposite is called expansionary monetary policy, and the central banks use it to stimulate growth. The lowers the discount rate, which means banks have to lower their interest rates to compete. This increases the money supply, spurs lending, and boosts economic growth.