Question

7.Fed is open to changing bond policy

Fed policymakers signaled for the first time that they could increase or decrease stimulation of the economy in the​ future, but not now.

​Source:

Los

Angeles

Times​,

May​ 1, 2013

What are the ripple effects and time lags that the Fed must consider in deciding when to increase or decrease stimulation of the​ economy?

Choose the statement that is correct.

A.

When the Fed lowers the federal funds​ rate, the exchange rate falls a few weeks later.

B.

When the Fed raises the federal funds​ rate, the inflation rate decreases about two years later.

C.

When the Fed lowers the federal funds​ rate, the supply of loanable funds increases up to a year later.

D.

When the Fed raises the federal funds​ rate, other​ short-term interest rates rise a few weeks later.

E.

When the Fed raises the federal funds​ rate, the quantity of money decreases on the same day.

Answer 1

Fed cam stimulate economic activity through changes in the interest rate. Fed can directly affect and stimulate economic activity through the Federal Fund Rate. The Federal Fund rate is the interest rate that the Banks charge while lending federal reserves to other banks, on an uncollateralized basis. It is one of the most important macroeconomic tools as it directly affects the monetary and financial aspects of the economy. The federal fund rate also represents the opportunity cost of holding reserves. A higher federal fund rate increases the opportunity cost of holding reserves. Higher the rate, smaller the quantity of reserves that the Banks plan to retain. Fed controls the supply of reserves through Open Market Operations. To increase the supply of reserves the Fed conducts an open market purchase and vice versa to increase the supply of reserves. With the increase in the supply of federal reserves, the quantity of reserves demanded increases and consequently the Federal Fund rate falls. The opposite happens when the supply of federal reserves decrease. When the Fed changes the federal fund rate, many key economic indicators are simultaneously affected. This creates a ripple effect throughout the economy.

When fed lowers the Federal Fund rate, other short-term interest rate and the exchange rate falls immediately. This happens as the Banks are now more likely to meet their reserve requirements and the amount of lending in the economy increases. Assuming all other Central Banks maintains the same or lower interest rate, a lower interest rate in the US will decrease the return on saving. So, the interest rate is lowered and the exchange rate falls, weakening the dollar. Due to higher lending, the amount of money in the economy increases. Supply of loanable fund increases, thus decreasing the longterm interest rate. The amount of consumption, expenditure in the economy increases. There is a higher level of economic activity. Aggregate demand increases and price level increases which accelerate inflation. Unemployment decreases in the short run.

However, there is a response lag or time lag for all these effects to take place. The variables do not adjust instantaneously. The fall of interest rate and exchange rate happens immediately as the Banks being rational institutions will start giving out more loans immediately if the Fed lowers the rate. The effects on the money supply follow after that (around 4 weeks later). Spending, consumption and real GDP are slower to respond as the economic agents do not revise these immediately and takes about a year of time to adjust. After consumption and GDP adjusts, aggregate demand gets affected and finally, the inflation rate is affected after a year or two.

So, the option (B) is correct i.e, When the Fed raises the federal funds rate, the inflation rate decreases about two years later.