Question

Analyze the effects of an increase in the money supply , inflation and how the FED selects the target federal funds rate and the important job or the trading desk. Describe direct and indirect effects and give examples for each

Answer 1

The Fed has been mandated by law to maintain 2 policy objectives:

(a). Keeping inflation in check

(b). Maintain high and stable unemployment.

Now, the problem is that the fed does not (or can not) directly control these variables (inflation, output or employment). It affects these vital economic variables indirectly through what is called federal funds rate.

All banking instiuitions are required to maintain a minimum amount of cash reserves with the fed. To maintain these reserves, sometimes some banks can borrow from fed or among each other. Fed funds rate is the rate at which banks can borrow funds overnight to maintain these reserves requirement.

Fed maintains a targeted federal funds rate considering inflation in the economy. If the inflation is too high the targeted funds rate will be high (called contractionary monetary policy) and if inflation is too low then it sets lower funds rate (easy or expansionary monetary policy). Through its monetary policy tools, fed changes this targeted funds rate.

The direct impact of a change in funds rate is that it changes the all other short-term interest rates in the same direction i.e. an increase (/decrease) in funds rate increases (/decrease) all short-run interest rate .

The indirect impact of increase (or decrease) in funds rate is that it increase (or decrease) long-run interest rates in the economy and thereby changing the amount of money, amount of credit and finally output and inflation. So. we have a kind of chain reaction of the following kind

increase in funds rate > higher cost of borrowing in the short-run (and also long run eventually) > less credit available > less money > output comes down > Prices come down.

decrease in funds rate > lower cost of borrowing in the short-run (and also long run eventually) > more credit available >more money > economy expands > Prices go up.

Role of trading desk:

Fed has various ways through which it transmits funds rate in the economy and one of most frequently used method is open-market operations (OMOs). It means buying and selling government securities in open market to change credit availibility and hence the funds rate.

An open maket sale of government securities will decrease money supply (credit available) with the banks in the economy as fed sells this government securities in return of money. Similarly, an open maket purchase of government securities will increase money supply (credit available) with the banks as the Fed will pay these banks for the purchase.

The Federal Reserve Bank of New York has a trading desk that does this every day. Two floors of traders and analysts monitor interest rates all day. If the funds rate is targeted low they purchase government securities and if it is too be kept high, it sells government securities.