Question

Why does the Federal Bank increase the supply of reserves when output rises if it is targeting the federal fund rate? What would happen to the federal fund rate if output rose and the Federal Bank held the supply of reserves fixed?

Answer 1

Federal Bank increases the supply of reserves in the mentioned scenario, because the Federal bank wants to decrease the Federal fund rate and the existing federal fund rate is higher than the target federal fund rate. When Federal bank increases the supply of reserves, then money supply shifts to the right and Federal fund rate decreases and achieves the target level.

If output rises, and supply of reserves is fixed, then federal fund rate is going to increase. It happens, because consumption and investment spending increases with increase in output. As a result, demand for money increases and shifts to the right. It increases the federal fund rate in the economy.