Question

a. If the Fed is targeting interest rates, what is the policy tool it needs to use? Explain what is Fed sacrificing, when it targets interest rate.

b. If the Fed is targeting money supply growth rate, what is Fed sacrificing? Can the target bee costly for the economy? Please explain

Answer 1

a. In order to target interest rates, the Fed uses open market operations in order to affect a change in the interest rate. The Fed buys bonds in order to increase the money supply and thus reduce the interest rates. On the other hand, the Fed sells bonds in order to reduce the money supply and increase the interest rate.

Fed is sacrificing amount of unemployment when it targets a higher interest rate, while it tries to control the inflation rate. As in such a case, people spend less and reduce investments. At the same time it is sacrificing economic stability when it targets lower interest rates as people tend to go for riskier assets.

b. If Fed is targeting money supply growth rate, the Fed is sacrificing the stable rate of inflation as the rate of inflation might increase exponentially led by an increase in money supply growth rate. While it might reduce drastically when money supply growth reduces.

The target can be costly for the economy when the increase in money supply causes too much demand in the economy and makes the goods costly. This will ultimately reduce the purchasing power of the currency and makes it expensive to opt for targeting money supply growth rate as the economic stability is hampered and long term solutions are required to address the issue.