Question

In: Economics

It is widely believed that at the next Federal Reserve meeting, the Federal Reserve will vote...

It is widely believed that at the next Federal Reserve meeting, the Federal Reserve

will vote to raise the Federal Funds rate.

a) Why would the Federal Reserve raise interest rates (fed funds) in a booming

economy?

b) What is the Fed funds rate? What is the discount rate? How are they

different?

c) Using the Liquidity Preference Model, illustrate what happens to interest rates

when the Federal Reserve sells bonds to banks.

d) Illustrate using the neoclassical synthesis model (AD/AS/LRAS) an economy

in an inflationary gap. Now illustrate what would happen if the Federal Reserve

raised interest rate

Solutions

Expert Solution

(a)

A booming economy indicates a high aggregate demand which increases inflation. So Fed may raise interest rate to reduce inflation.

(b)

Fed funds rate (FFR) is the interest rate charged by commercial banks for loans they extend to one another in the interbank credit market. But discount rate is the interest rate that Fed charges to commercial banks, for the loan Fed extends to commercial banks.

(c)

When Fed sells bonds, money supply decreases, shifting money supply curve leftward, increasing interest rate and decreasing quantity of money.

In following graph, MD0 and MS0 are initial money demand and supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. As money supply falls, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

(d)

Higher interest rate lowers investment, reducing aggregate demand, shifting AD curve leftward, decreasing both price level and real GDP.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial long-run equilibrium price level P0 and initial equilibrium real GDP (= Potential GDP) Y0. Current economic position is at AD1 which intersects SRAS0 at point B to the right of LRAS0, with higher real GDP Y0 and higher price level P1, causing an inflationary gap of (Y1 - Y0). When investment falls, AD1 shifts leftward to AD0, restoring long run equilibrium at point A, eliminating inflationary gap.


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