Question

"Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp rise in the inflation rate. What change in the Federal funds rate would you recommend? How would your recommended change get accomplished? What impact would the actions have on the lending ability of the banking system, the real interest rate, investment spending, aggregate demand, and inflation?"

answer should be 300 words

Answer 1

Inflation can be controlled by increasing interest rate. It can be recommended that the Federal Fund rate be increased to arrest the rising inflation rate in the economy. Given the inverse relationship between federal fund rate and money supply, given teh money demand in the economy. The Federal fund rate can be increased if the money supply in the economy is reduced. This can be achieved by exercising a contractionary open market operation where the Fed will reduce the money supply in the economy by purchasing the government bonds from public and commercial banks. The money supply will be reduced. The vertical money supply curve shifts left and the interest rate increases. The reduced money supply also means that the banks have reduced lending ability. This is because banks will have reduced credit to lend. As a result of reduced money supply, interest rate will rise. Increase in interest rate imply that the opportunity cost of borrowing has increased. This means that now investment has increased cost in terms of interest payments on borrowings. High interest rate will disincentivise the investors and will reduce investment spending. Investment spending is a major component of Aggregate demand (AD = C+I+G+X-M). The reduced investment spending reduce aggregate demand in the economy. As a result, reduced aggregate demand will shift the AD curve in the AD-AS setup to the left. As a result the price level and output level falls in the economy. Inflation that is change in price level will also fall. Thus interest rate and inflation has a negative relationship. To reduce inflation rate, the interest rate or the Federal Fund rate must be increased and vice versa.