Question

using the monetary policy transmission from chapter 17, show (graph) and explain the Fed's policy (i.e. raise or lower the federal funds rate) if the fed fights inflation. show how the Fed's policy affects the federal funds rate, loanable funds market, the exchange rate, and aggregate demand.

Answer 1

Money demand and supply graph can drawn with Money on the X axis and interest rate on the y axis as below:

When there is high inflation means banks have more money to lend and overall purchasing power of the citizens are high because of easy availability of money. Hence Fed needs to increase the federal funds rate. Increasing the Fed funds rate (as shown in graph i* is increased to i_S* ) will make Banks to take less loans for Reserves (as seen in right graph that demand for reserves has decreased to R_s) and maintain the Reserves from their own deposits. Hence money supply will decrease (as shown in left graph S has shifted to S_S and thus interest rates will also increase (as shown in left graph r* has sifted to r_s* ) and citizens will tend to take less loans, hence money demand will also decrease (as shown in left graph M has shifted to M_s. Hence Inflation Rate will tend to come down. The entire mechanism is shown in graph below:

Since on high fed funds rate Banks will tend to meet their Reserve requirements by their own deposits, loanable funds will reduce and hence loan interest rates will increase as shown in above graph already.

A higher interest rate in a country will attract foreign investments hence demand for the country's currency will increase and hence the exchange rate of the currency will appreciate.

Due to higher interest rate the purchasing power of the citizens are low they will demand less goods and hence aggregate demand will fall. As shown in graph AD curve has shifted to AD_s and Q has shifted to Q_s