Question

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp economic downturn. What change in the federal funds rate would you recommend? How would your recommended change get accomplished? What impact would the actions have on the lending ability of the banking system, the real interest rate, investment spending, aggregate demand, and inflation? What other tools of monetary policy could you use and how?

Respond to the topic and to one other student post by name (minimum word count is 150 for the initial post)

Answer 1

I would recommend a decrease in fed funds rate to ease the competition for lonable funds among banks and in turn among the consumers. This will make borrowing cheaper in the economy. To achieve this change, the reserve requirement can be decreased which will leave commercial banks with more excess reserves for loaning out and this will decrease fed funds rate. The bank is more equipped to lend out more money now because of the excess reserves it has. As borrowing is cheaper now, the real interest rate falls. This increases returns on investments and investment spending rises in the economy. This leads to increase in aggregate spending and hence aggregate demand of the economy. The rise in aggregate demand can be viewed as rightward shift in AD curve which raises prices (inflation)..

Other tools that could be used here are - open market operations to purchase securities and bonds, lowering interest paid on excess reserves.